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
Date Written: April 2020
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: Suggested Citation