Modeling CO2 Emission Allowance Prices and Derivatives: Evidence from the European Trading Scheme

Abstract

This paper studies the three main markets for emission allowances within the European Union Emissions Trading Scheme (EU ETS): Powernext, Nord Pool and European Climate Exchange (ECX). The analysis suggests that the prohibition of banking of emission allowances between distinct phases of the EU ETS has significant implications in terms of futures pricing. Motivated by these findings, we develop an empirically and theoretically valid framework for the pricing and hedging of intra-phase and inter-phase futures and options on futures, respectively.

Keywords: Emission Allowances, Futures, Options on Futures, Derivative Pricing

JEL Classification: G13, G15, G32