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Equilibrium Price Dynamics of Emission Permits

Published online by Cambridge University Press:  03 July 2018

Abstract

This article presents a stochastic equilibrium model for environmental markets that allows us to study the characteristic properties of emission permit prices induced by the design of today’s cap-and-trade systems. We characterize emission permits as highly nonlinear contingent claims on economy-wide emissions and reveal their hybrid nature between investment and consumption assets. Our model makes predictions about the dynamics and volatility structure of emission permit prices, the forward price curve, and the implications for option pricing in this market. Empirical evidence from existing emissions markets shows that the model explains the stylized facts of emission permit prices and related derivatives.

Type
Research Article
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2018 

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Footnotes

1

We thank Antje Berndt, René Carmona, Marc Chesney, Karl-Martin Ehrhart, Sang Baum Kang, Rüdiger Kiesel, Dominik Möst, Paulo Pereira, Christian Schlag, Philipp Schuster, Siegfried Trautmann, Michael Triskatis, Clemens Völkert, and Volker Vonhoff, as well as participants at the 2009 International Ruhr Energy Conference, the 2010 Campus for Finance Research Conference, the 2010 Industrial-Academic Forum on Commodities, Energy Markets, and Emission Trading at the Fields Institute (Toronto), the 2010 World Congress of Environmental and Resource Economists, the 2010 Energy Finance Conference, the 2011 Annual Conference of the Swiss Society for Financial Market Research, the 2011 Financial Management Association European Conference, the 2011 European Financial Management Association Annual Meetings, the 2011 International Congress on Industrial and Applied Mathematics, the 2011 Annual Meeting of the German Finance Association, the 2011 Financial Management Association Annual Meeting, the 2013 Annual Meeting of the German Academic Association for Business Research, the 2013 Applicable Semiparametrics Conference, and the Universities of Duisburg-Essen and Zurich for valuable discussions and helpful comments and suggestions. The article greatly benefited from comments by Hendrik Bessembinder (the editor) and Gurdip Bakshi and Bryan Routledge (associate editors and referees). Financial support by the Graduate School 895 “Information Management and Market Engineering” at the Karlsruhe Institute of Technology (KIT), funded by Deutsche Forschungsgemeinschaft (DFG), is gratefully acknowledged. An earlier version of this article was circulated under the title “Understanding the Price Dynamics of Emission Permits: A Model for Multiple Trading Periods.”

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