Pricing and hedging in carbon emissions markets

We propose a model for trading in emission allowances in the EU Emission Trading Scheme (ETS). Exploiting an arbitrage relationship we derive the spot prices of carbon allowances given a forward contract whose price is exogenous to the model. The modeling is done under the assumption of no banking of carbon allowances (which is valid during the Phase I of Kyoto protocol), however, we also discuss how the model can be extended when banking of permits is available. We employ results from filtering theory to derive the spot prices of permits and suggest hedging formulas using a local risk minimisation approach. We also consider the effect of intermediate announcements regarding the net position of the ETS zone on the prices and show that the jumps in the prices can be attributed to information release on the net position of the zone. We also provide a brief numerical simulation for the price processes of carbon allowances using our model to show the resemblance to the actual data.