Hedging and temporal permit issuances in cap-and-trade programs: the Market Stability Reserve under risk aversion
56 Pages Posted: 17 Aug 2019 Last revised: 3 Dec 2020
Date Written: November 30, 2020
Cap-and-trade programs such as the European Union’s Emissions Trading System (EU ETS) expose firms to considerable risks, to which the firms can respond with hedging. We develop an intertemporal stochastic equilibrium model to analyze the implications of hedging by risk-averse firms. We show that the resulting time-varying risk premium depends on the size of the permit bank. Applying the model to the EU ETS, we find that hedging can lead to a U-shaped price path, because prices initially fall due to negative risk premiums and then rise as the hedging demand declines. The Market Stability Reserve (MSR) reduces the permit bank and thus, increases the hedging value of the permits. This offers an explanation for the recent price hike, but also implies that prices may decline in the future due to more negative risk premiums. In addition, we find higher permit cancellations through the MSR than previous analyses, which do not account for hedging.
Keywords: cap-and-trade, emission trading system, risk aversion, hedging, EU ETS, Market Stability Reserve
JEL Classification: D25, H23, Q02, Q54, Q58
Suggested Citation: Suggested Citation