Carbon Emission Permit Price Volatility Reduction via Financial Options
34 Pages Posted: 18 Jul 2014
Date Written: October 16, 2012
We develop a stylized model to investigate the impact of financial options on reducing carbon permit price volatility under a cap-and-trade system. The existence of an option market provides a mechanism to hedge the uncertainty of future spot prices and is a stimulus for investment in carbon emission abatement technologies. We show that both the spot price level and the price volatility of carbon permits can be reduced via the trading of financial options, while achieving the emission reduction target. We also show that introducing financial options in a banking environment offers more flexibility to risk management in carbon permit trading.
Keywords: Carbon permit trading, financial options, volatility mitigation, emission permit pricing
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