EU ETS Futures Spread Analysis and Pricing Contingent Claims Under Different Market Schemes

The European Union Emission Trading Scheme is the largest market mechanism yet implemented to spur emissions reduction. In the scheme emissions certificates are traded within annual periods to compensate for the total emissions of given companies. The rules for how certificates can be passed from one annual period to another is phase dependent. During phase II of the EU ETS, emissions can be borrowed between years falling within phase II, but not from phase III years. We are interested in investigating the way in which this structural change affects the impact of unexpected release of information on futures returns. We propose a continuous-time model that depicts the relationship assimilated into the spread. We assume that two futures that mature at subsequent dates are traded. Their dynamic is driven by Brownian motions augmented by two jump processes. The discontinuous component reflects the impact of any unexpected release of information. We estimate the model parameters and draw economic conclusions. Furthermore our empirical results supports the stance that the market is mature and efficient enough to be comparable to other many futures markets. We present a pricing solution based on the Follmer-Schweizer decomposition. The optimal hedging strategy depends on all traded futures and minimizes the mean conditional square error of the cumulative process. We show how the fair price of any contingent claim can theoretically be computed in this context. Pricing examples under different market schemes are investigated