The Endogenous Price Dynamics of the Emission Allowances: An Application to CO2 Option Pricing

Market mechanisms are increasingly being used as a tool for allocating somewhat scarce but unpriced rights and resources, such as air and water. Tradable permits have emerged as the most cost–effective measure leading to the emergence of both nationwide (SO2) and supranational (CO2) emission permits markets. By means of the dynamic optimization of companies which are covered by such environmental regulations, we develop an endogenous model for the emission permit spot price dynamics that also accounts for the presence of asymmetric information. In the model, the companies are characterized by exogenous pollution processes that, in the short term, are the underlying of the permit price dynamics. An extensive numerical exercise is carried out for the CO2 permit price in the European market. We introduce for the first-time in the current literature a CO2 option pricing model comparison. The option pricing method can be used for hedging purposes and for pricing CO2-linked projects and investments.