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The endogenous price dynamics of emission allowances and an application to CO2 option pricing

Chesney, Marc and Taschini, Luca (2012) The endogenous price dynamics of emission allowances and an application to CO2 option pricing. Applied Mathematical Finance, 19 (5). pp. 447-475. ISSN 1350-486X

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Abstract

Market mechanisms are increasingly being used as a tool for allocating somewhat scarce but unpriced rights and resources, and the European Emission Trading Scheme is an example. By means of dynamic optimization in the contest of firms covered by such environmental regulations, this article generates endogenously the price dynamics of emission permits under asymmetric information, allowing inter-temporal banking and borrowing. In the market, there are a finite number of firms and each firm's pollution emission follows an exogenously given stochastic process. We prove the discounted permit price is a martingale with respect to the relevant filtration. The model is solved numerically. Finally, a closed-form pricing formula for European-style options is derived.

Item Type: Article
Official URL: http://www.tandfonline.com/loi/ramf20
Additional Information: © 2012 Taylor & Francis
Library of Congress subject classification: G Geography. Anthropology. Recreation > GE Environmental Sciences
H Social Sciences > HB Economic Theory
Journal of Economic Literature Classification System: Q - Agricultural and Natural Resource Economics; Environmental and Ecological Economics > Q5 - Environmental Economics > Q53 - Air Pollution; Water Pollution; Noise; Hazardous Waste; Solid Waste; Recycling
Sets: Research centres and groups > Grantham Research Institute on Climate Change and the Environment
Collections > Economists Online
Rights: http://www.lse.ac.uk/library/usingTheLibrary/academicSupport/OA/depositYourResearch.aspx
Date Deposited: 08 Oct 2012 14:15
URL: http://eprints.lse.ac.uk/46668/

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