Supply-side perspective for carbon pricing

Abstract

This paper theoretically and empirically revisits carbon pricing from the supply-side perspective for carbon assets to solve the recent low price issue which may delay the development of emission reduction technologies in the sense of marginal abatement costs. We propose a carbon pricing model linked to crude oil prices, which has historically been employed in supply-side driven pricing of long-term contracts for early-stage energy trading. Since the model is designed to hold carbon prices between certain lower and upper boundaries using S-shaped carbon price linkage to crude oil prices, it can be useful to overcome a recent low carbon price issue. In addition, it is shown that the model can alleviate the difficulties of carbon derivative pricing in selecting market price of risk. Empirical studies using EUA and Brent crude oil futures prices estimate the parameters of the Brent crude oil-linked EUA price model. The comparison of EUA prices simulated from the model with historical EUA prices suggests that simulated EUA prices be kept relatively higher than historical EUA prices. This is preferable for accelerating carbon emission reductions in that it can make emission reduction technologies with high marginal abatement costs affordable. It may imply that EUA must be priced using a crude oil-linked carbon price model in the early stage of EUA trading until EUA markets mature. This is a sharp contrast to current carbon markets employing premature market-based or supply and demand based pricing models. To show usefulness of crude oil-linked carbon pricing, we also give a numerical example of European carbon option pricing based on the Brent crude oil-linked EUA price model by using the Crank-Nicolson finite difference method. Finally we discuss the relation between crude oil-linked carbon pricing and emission reduction risk. These studies may suggest carbon policy makers should take account of crude oil-linked carbon pricing to tackle low price and low liquidity issues of carbon assets.