Modeling Carbon Emission Allowance Trading in China’s ETS

Abstract

This paper develops a game model to depict the process of determining the trading price and volume at equilibrium of Chinese carbon emission allowance trading market. Assuming that the cost for carbon emission reduction is a normally distributed random variable, enterprises are risk-neutral, and the total quantity of emissions allowances for the whole carbon market is a given, exogenous variable, carbon emission allowance price is a linear function, the model shows that CO2 price and volume are both affected by the magnitude and variance in the carbon reduction costs borne by companies and the reduction targets of the government. More specifically, the ratio between variances in costs and in reduction targets is associated with the speed of changes in CO2 price and rate of change in CO2 volume. This theoretical model should enhance our understanding of the mechanism of carbon trading price and volume of cap-and-trade system.