Risk-neutral models for emission allowance prices and option valuation

The existence of mandatory emission trading schemes in Europe and the United States, and the increased liquidity of trading on futures contracts on COz emissions allowances, led naturally to the next step in the development of these markets: These futures contracts are now used as underliers for a vibrant derivative market. In this paper, we give a rigorous analysis of a simple risk-neutral reduced-form model for allowance futures prices, demonstrate its calibration to historical data, and show how to price European call options written on these contracts. Key words: emission derivatives; emissions markets; cap-and-trade schemes; environmental finance History: Received April 25, 2009; accepted March 7, 2011, by Haitao Li, guest editor, finance. Published online in Articles in Advance June 20, 2011.
1. Introduction Global warming and environmental problems continue to challenge policy makers. In part because of the success of the U.S. Acid Rain Program, cap-and-trade systems are now considered to [...]