E

vidence of extreme volatility in the European permit

markets suggests the urgent need for the development
of selective hedging techniques such as futures contracts
and option instruments. As a result, a valid price model is
required for pricing nancial instruments or projects whose value
derives from the future carbon dioxide (CO
2
) spot permit price. Due
to the recent introduction in the market of option-like instruments
for hedging purposes, various models were developed to approximate
the dynamics of spot prices for CO
2
emission allowances. Dierent
approaches to the modelling of European Union emission allowances
(EUAs) ourished in the literature, ranging from equilibrium models
considering one trading period, to models derived from empirical
studies based on the rst two phase periods.
1 Modelling the dynamics of CO
2
emissions
Presently, the relevant spot price history is still short and may be
distorted by potential one-time eects due to the markets immature
state. Nonetheless, various authors considered the qualitative and
quantitative properties of the data, based on time-series analysis and
distribution analysis of the time series, to devise pricing models.
However, as opposed to equilibriummodels, all these empirical models
do not yet consider the fundamental properties of permit contracts.
1.1 Abatement opportunities
One of the key understandings in economics is that in an ecient
market, the equilibrium price of emission allowances is equal to the
marginal costs of the cheapest pollution abatement solution. Hence,
at a given time t, a company emitting CO
2
has to decide whether
to invest in infrastructure to reduce fuel production or delay the
investment to a future time, and instead buy emission allowances.
However, the fact that a market-based approach leads to an ecient
allocation of abatement costs across dierent polluters strongly
depends on the assumption that any technological abatement
solution is perceived as a perfect substitute for emission allowances.
Unfortunately, this is no longer true in the presence of uncertainty
and Chao et al (1993) proved that most abatement technologies are
perceived as durable and irreversible investments compared with
emission allowances, which are seen to provide a greater exibility in
adapting to changing conditions.
Consequently, few options are available to the majority of
companies aected by emission trading and even fewer fall into
the list of short-term abatement possibilities. As a result, it is
reasonable to assume that companies optimise their cost function
by continuously adjusting their permit portfolio allocations and by
choosing the optimal permit amount to purchase or sell, considering
the payment of the penalty as an alternative to compliance (see
Chesney et al (2008)).
1.2 An equilibrium approach
In 2006, when insucient price history for the European Unions
emissions trading scheme (EU ETS) existed, Seifert et al (2006)
considered a theoretical equilibriummodel that incorporated the key
properties of the EU ETS, such as abatement and penalty costs, and
deduced the main properties of the resulting spot price process.
ese results should be accounted for when explicitly modelling a
CO
2
spot price process. Fehr et al (2007) showed that the success of
projects including a carbon nance component is determined by the
correct valuation of their returns, whose cashows are equivalent to
derivatives written on future carbon prices.
Further, they showed that the spot price must be positive and
bounded by the penalty cost and the cost of delivering any lacking
allowances. Later, this idea was pursued by other authors such as
Chesney et al (2008) and Carmona et al (2009a) to name just a
few. Assuming the existence of a single representative rm, they
considered a pollution process with an initial pollution level, initial
permit endowment and with corresponding boundary conditions.
In CO
2
equilibrium models, permit
prices are positive and bounded by the
penalty level. To obtain closed-form
solutions to the pricing of CO
2
derivatives,
DanielBloch models the permit price
as a function of a positive unbounded
process, and shows that there is no
equivalent probability measure whereby
the discounted spot price is a martingale
64 EnergyRisk.com March 2011
Cuttingedge

i
S
t
o
c
k
p
h
o
t
o
.
c
o
m
/
CARBON DERIVATIVES PRICING:
AN ARBITRAGEABLE MARKET
March 2011 EnergyRisk.com 65
Cuttingedge
Assuming that the companys pollution dynamics are exogenous
processes, they used that process to derive the price of the tradable
permit by minimising the companys total cost. at is, the tradable
permit is a function of the pollution process, which is the unique
source of risk in that model. It is interesting to note that since the
pollution process is not a tradable asset, its risk can not be hedged
away, and Chesney et al (2008) concluded that there is no need to
construct a risk-neutral probability measure for the pollution process.
ey are therefore implicitly assuming that the underlying asset is not
a tradable asset and that consequently, its discounted price does not
need to be a martingale under the risk-neutral measure.
However, the CO
2
permit is a tradable asset and to avoid
arbitrage when estimating its value one should construct an
equivalent probability measure such that the discounted spot price
is a martingale under that measure. In that setting, one can expect
either a shortage or a surplus situation at the end of the trading
period, meaning the company will either be holding worthless
permits or paying the penalty costs. Hence, in a wait-and-see
situation, the payout at maturity is that of an Asian call option
with a oating strike price so that emission allowances are option
contracts. e expected future permits net position is valued by
minimising the total cost of the rm, computed as the sum of the
cashows at the initial time and the potential penalties at the end
of the period. As a result, the spot price is a function of the penalty
level and the probability of a permit-shortage situation
S t,T ( ) = pe
r Tt ( )
P c
e
0,T ( ) > N F
t ( )
where c
e
(0, T) models the cumulative emissions in the trading
period [0, T], N is the amount of emission allowances handed out
by the regulator and p is the penalty cost. As the pollution process
is uncertain, the emission allowance price lies between zero and
the discounted penalty level S
t
[0, e
r(Tt)
p]. Each author species
a dierent process for the method of approximation of cumulative
emissions c
e
(0, t). In order to compute the probability P(.), each
author species the cumulative emissions with a dierent process
c
e
(0, t) = j
t
0
Y(s)ds where Y(.) is the emission rate following a particular
process. erefore, given the drift and diusion terms of the emission
rate one can deduce the CO
2
spot price. For ease of computation,
the emission rate is usually normally or lognormally distributed so
that the probability of a permit-shortage situation is the cumulative
distribution function of a standard normal random variable. However,
permit prices are inherently prone to jumps therefore, to enable
equilibrium models to reproduce these jumps, the distribution of the
emission rate must be modied accordingly (see Grull et al (2010)).
1.3 An empirical approach
Various authors have presented empirical studies using spot and
futures prices suggesting that CO
2
emission allowances price levels
are non-normally distributed with fat tails, and that the price
dynamics are nonstationary and exhibit abrupt discontinuous shifts.
For instance, Daskalakis et al (2006) considered various popular
jump-diusion processes from the equity market to approximate the
dynamics of CO
2
allowance contracts, using a maximum likelihood
(ML) approach to estimate the model parameters. ey showed
that the Merton model (1976) had the best performance in terms of
likelihood and parsimony. Further, Gagliardi (2009) stressed that
volatility exhibits clustering over time and proposed a Heston model
combined with jump components. eir ndings imply that the
EUAs have a proportional, non-meanreverting structure with jumps.
In their articles, they did not check for no-arbitrage conditions,
and considered the dynamics of the spot price under the historical
measure without compensating the drift for the jump process. As a
result, they performed analysis with an incorrect expected value of the
spot price. Unfortunately, these models do not take into consideration
the properties of the CO
2
spot price described in section (1.2). More
precisely, the processes involved do not consider the penalty function
and as a result are not bounded, which is in contradiction with the
characteristics obtained from the equilibrium models.
In addition, the analysis performed by the authors on futures
prices were done under the historical measure and the market
prices of risk were not considered. As we saw earlier, it can have
tremendous implications in the dynamics of the spot process,
resulting in misleading interpretation of market behaviour. To
illustrate our comments, we refer the readers to Paul et al (2010) who
presented another empirical study on the CO
2
spot prices where they
considered jump-diusion models and in particular the normal-
inverse Gaussian model. ese models were calibrated to EUA prices
ranging from January 2006 to March 2009 and model parameters
summarised in a table. In view of the market behaviour of the spot
prices during that period of time, the spot prices are clearly bounded
by the penalty costs, and the excess of permits allocated, combined
with a slower global economy, pushed prices down. It is therefore not
surprising that an unbounded process such as a geometric Brownian
motion exhibits a negative drift, with = 0.29.
Similarly, in the case of geometric Brownian motion with mean
reversion, the alpha term is negative so that the drift becomes
0.009( lnS), and for = 1, the drift is negative for most values
of the spot price. To conclude, in the geometric Brownian motion
with jumps, the jump size is given by
saut
= 2.28, so that in
all cases, the model parameters of the unbounded processes are
articially constrained so that their dynamics resemble those of
a bounded process. To remedy these drawbacks, we are going to
consider a spot process that take into consideration the properties of
the CO
2
emission allowances.
1.4 A risk-neutral approach
To ensure no-arbitrage in order to compute option prices, we need to
derive the dynamics of the spot price or that of the future price under
a risk-neutral measure. Carmona et al (2009b) addressed the problem
of risk-neutral modelling of emission permits and considered models
based on diusion martingales ending up with two values. ey
assumed a one-period setting with no banking allowed, and let the
carbon price at the compliance date be a random variable taking only
the values zero and p. Because of the digital nature of the terminal
allowance price, they focused on the event of non-compliance
and modelled the future price to match the terminal condition. It
amounts to modelling a hypothetical positive-valued random variable
I exceeding the boundary condition one at the end of the period.
To match the recent allowance price and the observed instantaneous
uctuation intensity, they assumed a deterministic volatility function
for the process I
t
, leading to a local volatility diusion process for
the allowance price. Further, they devised a non-compliance process
not hitting zero or one in a nite time with probability one, and as
a result they identied classes of martingales taking values in the
interval (0,1) for the normatised future price process. en, they
extended their model to a two-period setting by assuming that the
cap-and-trade system is terminated at the end of the second period.
66 EnergyRisk.com March 2011
Cuttingedge
2 An alternative approach
We propose to bridge the gap between theory and observed market
price behaviours by considering a stochastic dierential equation for
the carbon permit price that satises the fundamental properties of
the permit contracts. Rather than working directly with a bounded
process and focusing on the event of non-compliance, we are going
to consider a positive exogenous process bounded by the penalty
cost. Similarly to Carmona et al (2009b), the dynamics of the
normalised spot price take values in the interval (0, 1) but it is not
forced by a digital payout at the end of the trading period. In general,
the valuation of forward and futures contracts in the commodity
market can be divided into two groups. e rst group considers
a risk premium to derive a model relating short-term and long-
term prices, while the second group is closely linked to the cost and
convenience of holding inventories. In order to dene our model in a
non-arbitrage market, we are going to consider both approaches and
try to compute an equivalent probability measure.
2.1 Accounting for the penalty cost
We let [T
i 1
, T
i
] be the ith trading period and consider the penalty
costs K(T
i
) for lacking EUAs during the entire ith trading period.
Assuming multi-period trading, allowing for unlimited banking and
forbidding borrowing, we let the strike K(t) be piecewise constant
given by K(t) =_
n
i=1
k
i
I
[T
i
1, T
i
]
(t) where k
i
is a positive constant in the ith
trading period. Taking into consideration the properties of the spot
price described in section (1.2), we let ( X
t
)
t ~ 0
be a positive process
describing the unbounded spot price of emission allowances in the
range [0, ), and dene the CO
2
spot price S
t
as
S
t
= min X
t
, K t ( ) ( )
= X
t
X
t
K t ( ) ( )
+
= K t ( ) K t ( ) X
t ( )
+
(2.1)
where, the spot price S
t
is a positive process taking values in the interval
[0, K(t)]. We rst concentrate on modelling the spot price within the
single period of time [0, T]. If constant penalty costs p are paid at the
end of the trading period, their values at time t are K(t) =e
r(Tt)
p, while
if they are paid at any time t [0, T], their values remain constant.
Assuming the latter, the dynamics of the spot price are given by
dS
t
= d K X
t
( )
+
which is equivalent to the dynamics of a put option on the unbounded
process. e process X
t
has the predictable representation property,
which is not the case of the discontinuous process S
t
, so that the
market for options on the spot price is incomplete.
2.2 The dynamics of the spot price
Given the unbounded spot price X=(X
t
)
t [0, T]
, we consider the
derivative price S
t
= f (t, X
t
) written on the underlying X. We choose
to work with semimartingales, since in that framework stochastic
integration and nonlinear transformations are stable. Without loss of
generality, and with the aim of presenting our idea clearly, we let the
dynamics of the unbounded spot price X under the historical measure
P be given by this stochastic dierential equation (SDE)
dX
t
X
t
=
X
dt +
X
d

W
X
t ( ) (2.2)
where
X
is the historical drift and o
X
is the volatility of the
process, and satisfying the usual conditions for the SDE to have
a unique solution. We consider the convex function C(X
t
) of the
underlying price given by the call payout C(X
t
) =(X
t
K)
+
and apply
Tanakas formula to get its dynamic
dC X
t
( ) = I
X
t
K { }

X
X
t
dt +
+ I
X
t
K { }

X
X
t
d

W
X
t ( ) +
1
2
X
t
K ( )
X
2
X
t
2
dt
where o(.) is the Dirac function. In the case where the strike is a
function of time, we get the extra term I
{X
t
~K}
(dK(t)/dt)/dt. So, given
Equation (2.1), the dynamics of the spot price are
dS
t
= dX
t
dC X
t
( )
=
X
X
t
I
X
t
< K { }
dt +
X
X
t
I
X
t
< K { }
d

W
X
t ( )
1
2
X
t
K ( )
X
2
X
t
2
dt
where I
{X
t
<K}
=1 I
{X
t
~K}
. e volatility of the spot price o
S
=o
X
X
t
I
{X
t
<K}
is bounded and equal to zero when the unbounded process X is either
equal to zero or greater or equal to the strike, which is in accordance
with the properties of the theoretical spot price given in section
(1.2). However, it contradicts one of the fundamental properties of a
tradable asset, which states that the volatility must be almost surely
not zero to make the hedge possible (see Shreve (2004)). at is, if the
volatility vanishes, then the randomness of the Brownian motion does
not enter the spot, but it may still enter the derivative security, making
the spot price no-longer an eective hedging instrument. Hence, we
can directly conclude that the model for carbon trading is incomplete.
2.3 A no-arbitrage model
2.3.1 The risk premium approach
To avoid arbitrage, we want to define an equivalent probability
measure Q to the real-world probability P such that the discounted
stock price is a martingale under Q. Hence, we let S
_
t
=e
rt
S
t
be the
discounted spot price, which we dierentiate with respect to time to
get its dynamics under the historical measure as
dS
t
= re
rt
X
t
I
X
t
K { }
dt re
rt
KI
X
t
K { }
dt +e
rt
I
X
t
K { }

X
X
t
dt +
+e
rt
I
X
t
K { }

X
X
t
d

W
X
t ( )
1
2
e
rt
X
t
K ( )
X
2
X
t
2
dt
e standard approach would be to compare the annualised rate of
return of the spot price per unit of time
X
to a risk-free investment
and consider
X
r as the reference parameter. However, this is
no-longer the case, and instead we must consider

X
= r +
S

X
+r
K
X
t
I
X
t
K { }
I
X
t
K { }
+
1
2
X
t
K ( )
I
X
t
K { }

X
2
X
t
so that the market price of risk becomes

S
=

X
r r
K
X
t
I
X
t
K { }
I
X
t
K { }

1
2
X
t
K ( )
I
X
t
K { }

X
2
X
t

X
which is only dened if o
X
0 and X [r, K r] where r > 0, that is,
o
S
0. However, we saw in section (2.2) that o
S
vanishes on some
part of the domain. In other words, for the no-arbitrage condition
to apply, the market price of risk must satisfy the Novikov condition
(see Shreve, (2004)). Hence, the no-arbitrage condition is not
satised when the unbounded spot price X
t
is greater or equal to the
penalty cost K. As a result, we cannot construct the dynamics for
the spot price and use the change of measure theory to express it
under an equivalent probability measure. Hence, in that setting there
is no equivalent probability measure such that the discounted spot
price S
_
t
is a martingale and we must therefore consider an alternative
approach. In the next section we are going to see if we can apply the
convenience yield approach to solve the problem.
March 2011 EnergyRisk.com 67
Cuttingedge
2.3.2 The convenience yield approach
Assuming the existence of a benet or a cost attached to holding
one unit of the spot price, the dynamics of the spot price under the
historical measure P are
dS
t
= I
X
t
K { }

X
X
t
dt + I
X
t
K { }

X
X
t
d

W
X
t ( )
1
2
X
t
K ( )
X
2
X
t
2
dt
where q(t, T) = -
1
2
o
2
X
X
2
t
is a convenience yield paid at all time t when
X
t
= K. is is consistent with the results obtained by Borak et al
(2006) where they found that a high fraction of the yields could be
explained by the price level and volatility of the spot prices. Since
the extra drift term q
~
(t, T) =-
1
2
o(X
t
K)o
2
X
X
2
t
is just a function of the
unbounded process X
t
, there is no additional source of risk to that
of the Brownian motion
X
(t). Hence, a standard approach would
be to compare the annualised rate of return of the spot price per
unit of time
X
to a risk-free investment and consider
X
r as the
reference parameter. Once again, considering the weak form of the
no-arbitrage condition, we get
I
X
t
K { }

X
X
t

S
= I
X
t
K { }

X
X
t
rX
t
I
X
t
K { }
rKI
X
t
K { }
so that the market price of risk becomes

S
=

X
r r
K
X
t
I
X
t
K { }
I
X
t
K { }

X
which is only dened if o
X
0 and X[r, Kr] where r > 0. erefore,
the no-arbitrage conditions do not apply, since the Novikov condition
is not satised. One possibility would be to modify the dynamics in
Equation (2.2) by adding the drift term
r
K
X
t
I
X
t
K { }
I
X
t
K { }
.
However, even though the market price of risk would be bounded, the
dynamics of the unbounded process would no longer be dened.
2.4 An arbitrage model
Various pricing methods exist, some of which are based on hedging
arguments, on the law of large numbers or as actuaries know it
on the standard deviation principle
1
, to name but a few. Recognising
that the discounted CO
2
stock price is not a martingale under an
equivalent probability measure that is, assuming the existence
of arbitrage opportunities in the carbon market we can therefore
arbitrarily dene the drift in the CO
2
spot price. We can either
assume a market price of risk and price in the corresponding
measure or we can directly price in the historical measure.
Accordingly, one must rely on the actuarial pricing approach of
marked-to-model. In that sense, the pricing of carbon permits
derivatives is very sensitive to the assumptions made and the choice
of a model for the underlying process.
2.4.1 The Black-Scholes measure
Given the dynamics of the spot price in Section (2.3.2), together with
its associated market price of risk, we assume that the growth rate of the
spot price is not far fromthe risk-free rate. erefore, following Black &
Scholes (1973), the market price of risk of the spot price becomes

S
=

X
r

X
Hence, the dynamics of the spot price under the Q

-measure are
dS
t
= I
X
t
K { }
rX
t
dt + I
X
t
K { }

X
X
t
dt
+ I
X
t
K { }

X
X
t
d

W
X
t ( )
1
2
X
t
K ( )
X
2
X
t
2
dt .
Using the change of measure, the Brownian motion W
t
given by
dW
t
= d

W
t
+
S
dt
is a Q

-Brownian motion, and the dynamics of the spot price under

the measure Q

become
dS
t
= I
X
t
K { }
rX
t
dt
1
2
X
t
K ( )
X
2
X
t
2
dt + I
X
t
K { }

X
X
t
dW
X
t ( ) (2.3)
One of the key assumptions in mathematical nance is that the market
price of risk is not specic to the traded asset but to its source of noise.
In our particular example, the unique source of noise of the spot price
is given by the Brownian motion
X
of the unbounded spot price. Even
though the unbounded spot price is not a tradable, one can not freely
specify its market price of risk with respect to a particular risk aversion,
as it has already been dened for the traded spot price. Hence, the
dynamics of the unbounded spot price under the measure Q

are
dX
t
X
t
= rdt +
X
dW
X
t ( )
which is the classical geometric Brownian motion used within the
Black-Scholes formula. In our setting, the dynamics of the discounted
spot price S

t
under the user-dened probability measure are
dS
t
= re
rt
KI
X
t
K { }
dt
1
2
e
rt
X
t
K ( )
X
2
X
t
2
dt
+e
rt
I
X
t
K { }

X
X
t
dW
X
t ( )
with extra drift term re
rt
KI
{X
t
~K}
dt. Since the spot rate and the
strike are positive, in this model, the growth rate is lower than the
risk-free rate. Using a deterministic setting, Rubin (1996) provided
a continuous time trading model for carbon permits and found that
the prices grow in equilibrium with risk-free interest rates. Later, as a
result of introducing uncertainty in Rubins model, Schennach (2000)
showed that the expected permit price growth rate was reduced, which
is also what we get in our model with the extra drift term q
~
(t, T) .
2.5 The forward price
Given the denition of the spot price in Equation (2.1), the forward
price under either the historical measure P or a measure Q

becomes
F t,T ( ) = E X
T
F
t

E X
T
K T ( ) ( )
+
F
t

= K T ( ) E K T ( ) X
T ( )
+
F
t

We see that as the CO

2
spot price has a xed upper bound given by
the penalty costs, the resulting forward price is an embedded option
on the unbounded price process equivalent to the strike minus a
discounted put option, and is therefore model-dependent. at is, the
forward price is a function of a European option on the unbounded
spot price and its associated volatility, and as such is no-longer linear.
Note, when the strike K is constant or time-dependent, as expected
in a single trading period, the option is a call or put option. However,
when the strike is stochastic, which could happen in multi-periods,
the option becomes an exchange option. Hence, given a process
for X
t
, we can compute the forward price at a given time, infer the
dynamics of the call or put option on X, and as a result, determine
1.
P(X) = E[X] +o[X], where o[X] corresponds to a risk premium
68 EnergyRisk.com March 2011
Cuttingedge
the dynamics of the forward price. One can choose the model of his
choice, and for simplicity of exposition, following the example given
in section (2.3.2) where X
t
is a geometric Brownian motion, we can
apply Its lemma to the function V(t, X
t
) and obtain the dynamics
dV t, X
t
( ) =
t
V t, X
t
( ) dt +
1
2

X
2
X
t
2

xx
V t, X
t
( ) dt +
x
V t, X
t
( ) dX
t
with the instantaneous volatility of the European option (the
forwardprice on S) being

x
V t, X
t
( )
V t, X
t
( )
X
t

X
which is bigger than the volatility o
X
of the spot price. Hence, in
that model, the holder of a forward contract must manage extra
volatility risk compared with empirical models that do not take
into consideration the penalty costs. Further, call option prices are
positive, convex functions of the underlying and are bounded by
V t, T; x, K ( ) x Ke
r T t ( )
( )
+
.
As a result, the forward prices in our model also exhibit these
properties. To conclude, in the forward market on carbon permits,
there is a single xed strike (the penalty cost) leading to an implied
term structure of volatility to be calibrated.
2.6 The option price
Since 2005, a CO
2
option market is slowly growing and attracting
a wide variety of industrials, utilities and nancial institutions of
various nature. is market satises the primary need of risk transfer
from those wishing to reduce the risk of permit shortage situation,
to those willing to accept it. As the tradable permit is an option
in disguise, an option on emission allowances should resemble a
compound option. at is, on the rst expiration date T
1
, the holder
has the right to buy a new call using the strike price K
1
where the
new call has expiration date T
2
and strike price K
2
. If we let the
current time be 0, the spot price is S, and C(S, ; K) denotes the
value of a call with time to expiry and strike price K, on the rst
expiration date T
1
, the value of a call on a call is
max K
1
, C S, T
2
T
1
; K
2
( )

= max C S, T
2
T
1
; K
2
( ) K
1
, 0

+ K
1
Letting P
_
(S, ; K) be the discounted put price and setting K
1
< K
2
,
the payout at maturity T
1
of a call option on the forward price is
max F T
1
, T
2
( ) K
1
, 0
( )
= max K
2
K
1
P X, T
2
T
1
; K
2
( ), 0

which we rewrite in terms of compound option payo as

K min K, P X, T
2
T
1
; K
2
( )

where K
_
=K
2
K
1
. Similarly, in the case of a call option on the permit
price, as the option strike cannot be higher than the penalty cost, we
must have the constraint K
1
< K
2
, and the payout at maturity T is
max S
T
K
1
, 0 ( ) = max X
T
X
T
K
2
( )
+
K
1
, 0

= max K
2
K
1
K
2
X
T
( )
+
, 0

which simplies to
max S
T
K
1
, 0 ( ) = max X
T
K
1
, 0 ( ) max X
T
K
2
, 0 ( )
is is the payo of a call spread on the unbounded process X.
erefore, in our model, the call price on the CO
2
spot price is lower
than that of an empirical model, not taking into consideration the
penalty costs. In the case of a put option the payout at maturity is
max K
1
S
T
, 0 ( ) = K
1
X
T
( )
+
which is equivalent to a put option on the unbounded process. Again,
given the dynamics of the unbounded process X we can then price
the European options in the risk-neutral measure. In the call-option
case, the payo is a convex and concave function such that its price
depends on two dierent volatility levels and such that the notion of
skew becomes important. It is interesting to note that vanilla options
on emission allowances become exotic options when considering
the unbounded process. As a result, the choice of a model for the
unbounded process X
t
is important, and one should consider empirical
results to infer its dynamics. All price series analysed in the literature
present non-zero skewness and excess kurtosis with summary
statistics of the data revealing fat-tailed leptokurtic distributions and
non-normal returns. Hence, for tractability reasons, an ane jump-
diusion model could be a plausible candidate.
2.7 Results
To illustrate our purpose, we consider the underlying given in section
(2.4.1) where X
t
is a geometric Brownian motion in the Q

measure
that is, the Black-Scholes model. We compute both a call option
and a call spread option on X
t
with maturity T=1, where the latter
is a call option on S
t
in our model. As emission allowance prices are
characterised in the literature by high historical volatility, we let the
volatility and drift be respectively o
X
= 0.4 and r = 0.05. is example
conrms that, assuming the same drift, the call prices obtained
with a bounded spot process are lower than those obtained with an
unbounded process. Hence, to recover the same option prices behaviour
with a model, not taking into consideration the penalty costs, one must
decrease the drift term, possibly obtaining negative drift.
2.7.1 Phase I
As a way of demonstrating the eect of neglecting the penalty cost,
K
2
= 40 in Phase I, we price a series of call options on S
t
and use the
results to infer the historical drift that calibrate a call option on X
t
in the historical measure around the strike K
1
= 32. We present the
results in table 1 where we let the strike vary in the range [20, 40],
assume the spot price to be S(0) =20 and obtain the historical drift
= 0.05, which is in line
with the results found by
Paul et al (2010).
In the Black-Scholes
model, the probability
P(X
t
~ K
2
) depends on
the initial spot price,
the maturity, the drift
and the volatility, so
that depending on the
parametrisation of the
model, the dierences
between the call prices
and the call spread prices
vary in magnitude.
Fixing the model
parameters and allowing
for the initial spot price
to vary in the range
[5; 35], we repeat the
T1. Call options &call spread options
in Phase I with varying strike
Strike Call Call spread Histor. call
20 3.6045 3.3565 2.7639
22 2.8008 2.5527 2.0739
24 2.1611 1.9131 1.5468
26 1.6589 1.4109 1.1490
28 1.2687 1.0207 0.8512
30 0.9679 0.7198 0.6298
32 0.7373 0.4892 0.4658
34 0.5612 0.3132 0.3447
36 0.4272 0.1792 0.2553
38 0.3254 0.0773 0.1894
40 0.2480 0.0 0.1407
Historical drift is = 0.05 Source: Author
March 2011 EnergyRisk.com 69
experiment by computing dierent call options in both models that
is, on X
t
and S
t
under the Q

measure. For comparison, we list the

call prices on X
t
in the historical measure with drift = 0.01.
On one hand we compute at-the-money call options, while on the
other, call options with xed strike K
1
= 20 are considered. e results
are presented in table 2 where in both cases the dierences between
the call prices and the call-spread prices increase as the initial spot
price tends to the boundary of the domain that is, the penalty costs.
is is an important result when pricing options on carbon, but more
importantly, it is crucial when hedging call options, as observed CO
2
spot prices are presently low and the discrepancy small, but in the
event of an increase in spot prices, the hedging strategy constructed
with an unbounded process will become misleading.
2.7.2 Phase II
In Phase II, the penalty cost has been increased to K
2
= 100 and
from 2006 to 2009 we saw that observed carbon prices decreased
due to an excess of permits allocated and a slower global economy.
erefore, keeping the model parametrisation as in Phase I but with
the new penalty cost, the probability P(X
T
~ K
2
) in Phase II is smaller
than that in Phase I, and the dierences between the call and call-
spread options are greatly reduced. However, the latest report from
the World Meteorological Organization (2010) stated that the main
greenhouse gases have reached their highest concentration levels since
pre-industrial times despite the economic slowdown, increasing the
likelihood of a reduction in the permits allocated by governments,
which in turn would result in an increase in CO
2
spot prices.
Conclusion
We proposed a CO
2
permit price model consistent with the features
exhibited by the CO
2
equilibrium models. To remain close to
classical option pricing theory and obtain closed-form solutions, we
directly modelled CO
2
permit prices as a function of an exogenous
and positive unbounded process and introduced one-period
contingent claims in terms of such a dynamics. In that setting, the
permit price is not a martingale under an equivalent probability
measure, which is consistent with empirical ndings, but implies the
existence of arbitrage opportunities. Following a marked-to-model
approach, we considered arbitrarily chosen growth rates for the CO
2
spot permit price, and computed European call option prices.
Daniel Bloch, Universit Paris VI Pierre et Marie Curie, France
Email: daniel.bloch@mizuho-sc.com
The author is grateful to Nicole El Karoui, Monique Jeanblanc, Mark Davis, Paul Mills as
well as to the referee for their useful comments and suggestions
Cuttingedge
T2. Call options &call spreadoptions inPhaseI withvaryingspot
Spot ATMcall Call spread Histo. call Call K=20 Callspread Histo. call
5 0.9011 0.9011 0.7716 0.0004 0.0004 0.0002
10 1.8022 1.8014 1.5433 0.1240 0.1231 0.0888
15 2.7034 2.6716 2.3150 1.1382 1.1064 0.9119
20 3.6045 3.3565 3.0867 3.6045 3.3565 3.0867
25 4.5057 3.5840 3.8584 7.2441 6.3224 6.4701
30 5.4068 3.1303 4.6301 11.5745 9.2980 10.6267
35 6.3080 1.9187 5.4018 16.2575 11.8682 15.2060
Historical drift is = 0.01 Source: Author
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