Abstract
We provide a valuation formula for emission allowance. Assuming that the value of emission allowance on the last day of a trading phase is equal to a spread of commodity prices (e.g. electricity and natural gas) when the spread is positive and less than the penalty, we show that the emission allowance price is equal to the value of a portfolio of European call options on the spread of the commodities. Using the formula, we obtain a hedging strategy for emission allowance trading. We also empirically analyze option value embedded in emission allowance, and find by numerical analysis that the option value is relatively large.
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