Pricing of CO2 Emission Allowance Derivatives

Abstract: The aim of this paper is to analyse the pricing of carbon emission allowance futures and futures options to see how they can help us understand the intuition behind spot prices of the underlying emission allowance. We use data from the third time period within the European Union Emissions Trading Scheme. There have been studies within this area before but only a few have incorporated the possibility of jumps in the spot price movement. We estimated risk-neutral parameters for the futures options using the Merton (1976) jump-diffusion model and the Duan (1995) GARCH-(1,1) model built on locally risk-neutral valuation relationship where consequently the model parameters can be estimated from the spot returns using maximum likelihood. Our results show that even though the estimates of the risk-neutral parameters are highly variable for the Merton model, it performs better than the GARCH-model and our chosen benchmark, Black's model (1976). The GARCH-model is applied using Monte Carlo simulations and greatly underperforms all other models in our study, most likely due to errors in the estimation or model specification.