Risk-neutral pricing of financial instruments in emission markets: A structural approach

DOI10.1137/140987365zbMATH Open1339.91118arXiv1011.3736OpenAlexW2082166031MaRDI QIDQ2808243FDOQ2808243

Authors: S. D. Howison, Daniel Schwarz 

Publication date: 20 May 2016

Published in: SIAM Review (Search for Journal in Brave)

Abstract: We present a novel approach to the pricing of financial instruments in emission markets, for example, the EU ETS. The proposed structural model is positioned between existing complex full equilibrium models and pure reduced form models. Using an exogenously specified demand for a polluting good it gives a causal explanation for the accumulation of CO2 emissions and takes into account the feedback effect from the cost of carbon to the rate at which the market emits CO2. We derive a forward-backward stochastic differential equation for the price process of the allowance certificate and solve the associated semilinear partial differential equation numerically. We also show that derivatives written on the allowance certificate satisfy a linear partial differential equation. The model is extended to emission markets with multiple compliance periods and we analyse the impact different intertemporal connecting mechanisms, such as borrowing, banking and withdrawal, have on the allowance price.

Full work available at URL: https://arxiv.org/abs/1011.3736

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zbMATH Keywords

backward stochastic differential equationsemilinear partial differential equationcap-and-tradeenvironmental financeemission markets

Mathematics Subject Classification ID

Derivative securities (option pricing, hedging, etc.) (91G20) Environmental economics (natural resource models, harvesting, pollution, etc.) (91B76) Applications of stochastic analysis (to PDEs, etc.) (60H30)

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Cited In (24)

• Stochastic modelling with randomized Markov bridges
• Optimal generation and trading in solar renewable energy certificate (SREC) markets
• Pricing renewable energy certificates with a Crank-Nicolson Lagrange-Galerkin numerical method
• The endogenous price dynamics of emission allowances and an application to CO\(_2\) option pricing
• PRICING AND HEDGING IN CARBON EMISSIONS MARKETS
• Numerical solution of a nonlinear PDE model for pricing renewable energy certificates (RECs)
• Singular forward-backward stochastic differential equations and emissions derivatives
• A methodology using option pricing to determine a suitable discount rate in environmental management
• Risk-neutral models for emission allowance prices and option values
• Risk Aversion in Modeling of Cap-and-Trade Mechanism and Optimal Design of Emission Markets
• A Forward-Backward SDEs Approach to Pricing in Carbon Markets
• A mean‐field game approach to equilibrium pricing in solar renewable energy certificate markets
• Pricing options on EU ETS certificates with a time-varying market price of risk model
• A scenario-based integrated approach for modeling carbon price risk
• On fair pricing of emission-related derivatives
• Model and numerical methods for pricing renewable energy certificate derivatives
• Risk-neutral pricing of financial instruments in emission markets: A structural approach
• Numerical approximation of singular forward-backward SDEs
• Climate uncertainty and carbon emissions prices: the relative roles of transition and physical climate risks
• Emission allowance as a derivative on commodity-spread
• First order strong approximations of scalar SDEs defined in a domain
• Optimal stochastic control and carbon price formation
• Jump-diffusion modeling in emission markets
• Pricing renewable identification numbers under uncertainty

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