SIGEST

Abstract

The SIGEST paper in this issue, “Risk-Neutral Pricing of Financial Instruments in Emission Markets: A Structural Approach” by Sam Howison and Daniel Schwarz, is from the SIAM Journal on Financial Mathematics. SIFIN is one of SIAM's newest journals, and this paper is SIFIN's first in SIGEST. This paper is a great, and all too rare, example of an application of advanced mathematics to public policy. The authors propose a new model for emissions trading. The Kyoto Protocol permits trading of credits for emission reduction. For example, a developing country can earn certified emission reduction (CER) credits for emission reduction projects, and then sell those credits to enable a company to offset its excess carbon production. Among the new features in the model are inclusion of existing trading schemes and policies, such as the SO$_2$ and NOx trading programs in place in the U.S. or the European Union Emissions Trading Scheme. The precise formulation and analysis of the model are, as you might expect, based on stochastic differential equations, and the later sections in the paper require some comfort with the mathematics. The authors have crafted an accessible introduction which puts the problem into perspective very nicely to create a fascinating account of the connection between sophisticated mathematics and public policy.