Floor-and-Trade Markets under Uncertainty: The Case of Renewable Identification Numbers (RINs)
53 Pages Posted: 19 Mar 2018 Last revised: 12 Oct 2018
Date Written: March 19, 2018
Renewable Identification Number (RIN) is a floor-and-trade mechanism to enforce renewable energy standards in the US transportation fuels market. Motivated by several real-world cases of gasoline producers' bankruptcy or financial stress caused by volatile RINs prices, we offer a dynamic stochastic optimization framework to determine the price behavior of RIN certificates and their connections to firms' operational decisions. One key novel aspect of our work is that we explicitly identify and model the embedded option value of RINs under various scenarios. We derive some closed-form solutions for the price dynamics of RINs, and also propose accurate numerical methods for when the closed-form solution is not available. Among other results, we show that the price of RINs has a U-shape relationship with the volatility of ethanol and gasoline prices and a negative relationship with the correlation between the two price processes. We compare the empirical performance of the model with real historical data, and find that our model allows a significant improvement over existing pricing models. We also discuss the interaction of operational features and constraints of blenders and the market price of RINs. We show how the analytic framework can be used to better inform operational decisions of firms active in markets with a floor-and-trade permit mechanism.
Keywords: Renewable Energy, Embedded Options, Floor and Trade Mechanism, Spread Option Pricing, Least Square Monte Carlo
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