Luca Taschini

The Endogenous Price Dynamics of Emission Allowances and an Application to CO2 Option Pricing

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 paper 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.

Pollution permits, Strategic Trading and Dynamic Technology Adoption

This paper analyzes the dynamic incentives for technology adoption under a transferable permits system, which allows for strategic trading on the permit market. Initially, firms can invest both in low-emitting production technologies and trade permits. In the model, technology adoption and allowance price are generated endogenously and are interdependent. It is shown that the non-cooperative permit trading game possesses a pure-strategy Nash equilibrium, where the allowance value rejects the level of uncovered pollution (demand), the level of unused allowances (supply), and the technological status. These conditions are also satisfied when a price support instrument, which is contingent on the adoption of the new technology, is introduced. Numerical investigation confirms that this policy generates a floating price floor for the allowances, and it restores the dynamic incentives to invest. Given that this policy comes at a cost, a criterion for the selection of a self-financing policy (based on convex risk measures) is proposed and implemented.

Conservation Payments under Uncertainty

The paper analyses the implications of landowners’ option values in land allocation and derives policy recommendations for payments for Reducing Emissions from Deforestation and Forest Degradation (REDD). Given that REDD will not represent a permanent change in the cumulative flux of carbon dioxide to the atmosphere, payment scheme design is motivated by the need to secure forest carbon sinks over time (the ‘permanence criterion’) while remaining relatively cost-effective. Alternative payment schemes, combining fixed and variable components, are considered in a framework with two competing land uses, forest and agriculture. Cost-effectiveness depends on the dependency structure between the returns from the indexed component of the payment and the returns from the alternative land use, the relative volatility level of the underlying returns, and the relative combination of fixed and variable payments. After developing the general model, it is is applied to REDD policy scenarios in Parana State, Brazil.The decision of whether to retain forest or convert to another land use is affected by uncertainty over future land use returns. This paper examines the design of conservation payments to landowners under uncertainty. Payments are either indexed to the returns from deforestation (agriculture), or to a market value associated with forest nonuse benefits. Payment size depends on the degree of correlation between payments and agricultural returns, and their relative volatility. Market-based payments for reducing emissions from deforestation and degradation (REDD) are simulated for Brazilian soybean growers. Payments indexed to carbon prices are larger than those indexed to international soybean prices.

Entry and Exit Decision Problem with Implementation Delay

We study investment and disinvestment decisions in situations where there is a time lag d > 0 from the time t when the decision is taken to the time t + d when the decision is implemented. In this paper we apply the probabilistic approach to the combined entry and exit decisions under the Parisian implementation delay. In particular, we prove the independence between Parisian stopping times and a general Brownian motion with drift stopped at the stopping time. Relying on this result, we solve the constrained maximization problem, obtaining an analytic solution to the optimal ‘starting’ and ‘stopping’ levels. We compare our results with the instantaneous entry and exit situation, and show that an increase in the uncertainty of the underlying process hastens the decision to invest or disinvest, extending a result of Bar-Ilan and Strange (1996).

Emissions Trading Systems with Cap Adjustments

Emissions Trading Systems (ETSs) with fixed caps lack provisions to address systematic imbalances in the supply and demand of permits due to changes in the state of the regulated economy. We propose a mechanism which adjusts the allocation of permits based on the current bank of permits. The mechanism spans the spectrum between a pure quantity instrument and a pure price instrument. We solve the firms’ emissions control problem and obtain an explicit dependency between the key policy stringency parameter – the adjustment rate – and the firms’ abatement and trading strategies. We present an analytical tool for selecting the optimal adjustment rate under both risk-neutrality and risk-aversion, which provides an analytical basis for the regulator’s choice of a responsive ETS policy.

The real option to fuel switch in the presence of expected windfall profits under the EU Emission Trading Scheme

This paper develops a simple model to evaluate the value and the activation frequencies of a generation system consisting of coal-fired and a gas-fired power plants using a real options approach, and the notions of clean-spark and clean-dark spreads. Under a cap-and-trade scheme, the use of emission permits represents an opportunity cost. In the energy industry different generation technologies produce different levels of CO2 emissions and, therefore, different opportunity costs. Addressing the question of how expected windfall profits affect the profitability of a generation plant and its activation frequencies, the paper shows that conventional findings are reversed. When the opportunity cost is internalized, the rate of activation of the gas plant decreases while that of the coal plant increases.

Linking Emission Trading Schemes: A Short Note

In principle, linking emission trading schemes would favour the depletion of low-cost abatement opportunities that are geographically spread over the globe. However, this would only be possible if the price of the emission permits in the different schemes converge to one price. Using a simple model-free structure, the paper first assesses how a unilateral link between two schemes or a bilateral link between schemes with restrictions on the amount of imported permits preempt a correct price convergence. Second, it shows under which conditions bilateral links between schemes with price containment mechanisms allows permit price convergence.

Carbon Dating: When Is It Beneficial to Link ETSs?

We propose a theory of the economic advantage (EA) of regulating carbon emissions by linking two emissions trading systems versus operating them under autarky. Linking implies that permits issued in one system can be traded internationally for use in the other. We show how the nature of uncertainty, market sizes, and sunk costs of linking determine EA. Even when sunk costs are small so EA>0, autarky can be preferable to one partner, depending on jurisdiction characteristics. Moreover, one partner’s permit price volatility under linking may increase without making linking the less preferred option. An empirical application calibrates jurisdiction characteristics to demonstrate the economic significance of our results which can make linking partner match crucial for the effectiveness and success of the Paris Agreement.

Dynamic Supply Adjustment and Banking Under Uncertainty: The Market Stability Reserve

The supply of allowances in the European Union Emissions Trading System is currently determined by a rigid allocation programme. The Market Stability Reserve (MSR) makes the allocation of allowances flexible and contingent on the aggregate bank, while preserving the overall emissions cap. We investigate under which conditions the MSR can alter the abatement and allowance price paths. We show that, for risk-neutral firms a cap-preserving MSR is largely irrelevant. The MSR will not influence the expected equilibrium allowance price or average price volatility. We then relax the risk neutrality assumption and investigate how the MSR can impact the risk of an unexpected breakdown of inter-temporal optimisation, ultimately affecting the equilibrium at different points in time. In this context, we show that changes to the timing of allowance allocation by the MSR can have a substantial impact on abatement and allowance price paths when firms are risk-averse.

The Issue of Climate Change

According to the Intergovernmental Panel on Climate Change (IPCC) which aggregates international research efforts on climate change, global atmospheric concentrations of greenhouse gases (CO2, CH4 and N2O) have increased markedly as a results of human activities since 1750. As their concentrations in the atmosphere intensify, GHG act as a radiation trap that forces more energy to stay on surface and more heat to be produced, therefore causing global warming. According to the sensitivity projections of the IPCC, any commitment to limit the global average temperature increase within a +2 °C limit would force to stabilize CO2 concentration around 350–400 ppm. However, until damages are elicited and adaptation cost monetized, the urgency of taking measure against global warming remains for many elusive. This chapter will present the two clearest possible strategies to limit the causes of climate change and its impact, mitigation and adaptation strategies and details their respective strengths and weaknesses. We show that to be effective, an a optimal policy against climate changes and their impacts will have to combine both mitigation and adaptation. While adaptation are easier to implement, bear less uncertainties and can be privatized (partially avoiding free-riding effects), mitigation strategies are the only capable to reduce GHGs in the atmosphere in order to reestablish a viable long-term CO2 concentration.