Volume 16 | Issue 1 | Article 1
Next Article >>
Back To: Table of Contents
Pricing the Cost of Carbon Dioxide Emission Allowance Futures
In January 2005 the new European Union Emissions Trading Scheme (EU ETS) signified a shift in paradigms of environmental policy in the European Union. Affected EU ETS companies can trade carbon dioxide emissions futures to meet their needs. Pricing and forecasting the carbon dioxide allowances and their futures are important to the risk management of many industrial companies. This paper investigates the relationship between carbon dioxide spot and futures markets, the changing market dynamics, and the volatility term structure. The differences in price behavior between the initial pilot period (2005–2007) and the Kyoto-commitment period (2008–2012) are also taken into account. We propose models tailored to stylized features of carbon dioxide spot prices as a result of mean-reversion with varying trends, combined with state-dependent price jumps and volatility structure. Closed-form solutions are derived for the price of futures on carbon dioxide allowances based upon the assumed spot price process. Our results show that mean-reversion with state-dependent price jumps fares better in forecasting the pilot-period futures prices whereas mean-reverting alone outperforms for the Kyoto-period futures on carbon dioxide allowances.
