What Can We Learn from the EU ETS Experience? Recommendations for Effective Trading and Market Design

Abstract

Cap-and-trade markets provide a policy instrument to encourage the decrease of harmful emissions such as global greenhouse gases over both short and long time periods. The European Union Emission Trading Scheme (EU ETS) is the largest carbon emission market yet implemented. Its design, which allows banking and borrowing, makes it different from all other commodity markets since the expectation of market participants has a dramatic impact on the trading volume. This paper introduces an emissions market model and fits it to the EU ETS data. An analysis of this model motivates recommendations for effective trading and market design. We describe futures allowance dynamics by a binomial tree with returns partially driven by the implied expected market position at subsequent compliance dates. By construction, the market is incomplete. We propose a pricing procedure and quadratic risk minimization hedging strategies. We show that the best hedging strategy must include positions in futures maturing at subsequent compliance dates. Consequently the trading compliance periods are correlated. To reduce this inter-period dependency, we recommend that the regulator introduce a new additional tradable primary asset. Such a solution allows non-emitters, who fear long term regulatory ambiguity, to participate in the market hence increasing its liquidity. We present a possible pricing framework based on the indifference pricing technique.