The endogenous price dynamics of emission allowances: an application to CO2 option pricing

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During the last decade we have been witness to a significant increase in the attention given by both policy makers and regulators to market-based environmental policy instruments. These are aimed at internalizing costs which previously had been met by those external to the production process, see Pigou (1918). Such policy instruments have emerged as a more cost–effective alternative to conventional command-and-control standards which had dominated the previous two decades of environmental laws and regulations.1 In addition to cost efficiency, a number of potential advantages of emission trading programs, compared to command-and-control allocation of emission targets, were identified (see Muller and Mestelman (1994)).

A program for tradable permits generates a clear price signal which guides firms in developing and evaluating new, more efficient pollution control technologies.2 From a political perspective, emission-trading programs are perceived as fairer, and thus more acceptable, than other forms of environmental regulation as they promote decentralized decision-making.

One of the first references to market-based techniques for dealing with pollution problems can be found in the seminal works of Coase (1960) and Dales (1968). In these papers the pollution abatement problem is viewed within an economic, cost-benefit framework in conjunction with the concept of property rights: Their essays propose the basic idea of tradeable permits. Based on such an idea, Montgomery (1972) provides a rigorous theoretical justification of how a marketbased approach leads to the efficient allocation of abatement costs across various sources of pollution.

Necessary and sufficient conditions for market equilibrium and efficiency are derived given the setting of multiple profit-maximizing firms who attempt to minimize total compliance costs. Theoretical aspects that Montgomery (1972) does not discuss have been addressed by the studies which follow below. The influence of uncertainty, regarding the regulation policy of public utility commissions on the behavior of regulated firms, have been discussed by Bohi and Burtraw (1992) and Coggins and Swinton (1996). Uncertainty and abatement cost function have been exploited by Stavins (1996). Hahn (1983) and Misolek and Elder (1989) have discussed such issues of market imperfection as the concentration in permit markets. Stavins (1995), Doucet and Strauss (1994) and Montero (1998) have developed models to include transaction costs in the theoretical frame. Cason (1993, 1995) has conducted an analysis on auction and rules design.

Literature focusing on the economic and policy aspects of this new market-based mechanism is extensive, but an explicit study of the dynamic emission permit price in the presence of market uncertainty is an almost unexplored area. Most of the present research relies on the key result - extensively demonstrated and discussed by environmental economists - that, in an efficient market, the equilibrium price of the emission allowances is equal to the marginal costs of the cheapest pollution abatement solution. This statement underpins the belief that a high price level for emission permits brings about the relevant companies with lower marginal abatement costs in order to exploit consequent price differences. Such companies make profits by lowering the level of offending gases more than is necessary to comply with regulations and subsequently sell their spare permits. Through the use of optimal–control theory, Rubin (1996) extends the discrete-time and deterministic setting of Tietenberg (1985) and Cronshaw and Kruse (1993) and provides a trading model for permits in continuous time. The author, introducing the possibility of banking and borrowing permits, demonstrates that the discounted marginal costs of abatement are, theoretically, constant over time. As a consequence the permit price grows in equilibrium with risk-free interest rates.

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