Hedging and Temporal Permit Issuances in Cap-and-Trade Programs: The Market Stability Reserve Under Risk Aversion

47 Pages Posted: 17 Aug 2019 Last revised: 21 Apr 2020

See all articles by Oliver Tietjen

Oliver Tietjen

Potsdam Institute for Climate Impact Research (PIK); Technical University of Berlin

Kai Lessmann

Potsdam Institute of Climate Impact Research

Michael Pahle

Potsdam Institute for Climate Impact Research (PIK)

Date Written: April 2020

Abstract

Cap-and-trade programs as the European Union’s Emissions Trading System (EU ETS) expose firms to considerable risks, to which they 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 rise thereafter since the hedging demand declines. The Market Stability Reserve (MSR) reduces the permit bank and thereby increases the hedging value of permits. This offers an explanation for the recent price hike, yet also implies that prices may decline in the coming years 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

Tietjen, Oliver and Lessmann, Kai and Pahle, Michael, Hedging and Temporal Permit Issuances in Cap-and-Trade Programs: The Market Stability Reserve Under Risk Aversion (April 2020). Available at SSRN: https://ssrn.com/abstract=3436736 or http://dx.doi.org/10.2139/ssrn.3436736

Oliver Tietjen (Contact Author)

Potsdam Institute for Climate Impact Research (PIK) ( email )

Telegrafenberg 31
Potsdam, Brandenburg 14473
Germany

Technical University of Berlin ( email )

Straße des 17
Juni 135
Berlin, 10623
Germany

Kai Lessmann

Potsdam Institute of Climate Impact Research ( email )

HOME PAGE: http://https://pik-potsdam.de/members/lessmann

Michael Pahle

Potsdam Institute for Climate Impact Research (PIK) ( email )

Telegrafenberg 31
Potsdam, Brandenburg 14473
Germany

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