Abstract
The price of permits in the European Union Emissions Trading System (EU ETS) has historically been highly sensitive and prone to jumps. We consider different stochastic processes to model the price of permits, and show that the Variance Gamma (VG) model provides the best fit for the price distribution, among a selection of infinite activity processes. Using this result as a starting point, we assess the effects of the EU ETS in delivering low-carbon investments at the firm level, by modeling a price taker electricity producer subject to the EU ETS jurisdiction. We compute, via Least Squares Monte Carlo, the value of the real option the greenhouse gas emitter has, consisting in the opportunity to switch from its current high-carbon technology to a cleaner one. We use a VG specification for carbon prices, and a mean-reverting (Brennan–Schwartz) process for the price of fuel. Moreover, we further analyze the investment decision problem, in case of a CO2 price stabilization mechanism in the form of a price floor, by explicitly computing the expected value of the investment project by means of Fourier methods. Our results show that the introduction of the price stabilization mechanism significantly affects the timing of the investment decision, and supports emission-related investments.
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