Abstract
In this paper we propose a market consistent futures price dynamics model for cap-and trade schemes, designed in the spirit of the European Union's Emissions Trading Scheme (EU ETS). Historical price dynamics for the EU ETS suggest that, both, European emission Allowances (EUAs) and Certified Emission Reductions (CERs), certificates which are generated through the Clean Development Mechanism (CDM) - a non-domestic offset mechanism - are significantly related. We use an equilibrium framework to demonstrate that compliance regulation singles out special joint futures price dynamics. Based on this result we propose an arbitrage free futures price model and apply it to the pricing of spread options between EUAs and CERs.
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