Integrated EUA and CER price modelling and application for spread option pricing

Produced as part of the The Munich Re programme: evaluating the economics of climate risks and opportunities in the insurance sector CCCEP research programme theme

Also known as Munich Re Technical Paper: 7

Abstract

In this paper, we propose a market consistent futures price dynamics model for cap-and-trade schemes, designed in the spirit of the European Union’s Emissions Trading Scheme (EU ETS).

Historical price dynamics for the EU ETS suggest that both European emission Allowances (EUAs) and Certified Emission Reductions (CERs) certificates, which are generated through the Clean Development Mechanism (CDM) – a non-domestic offset mechanism – are significantly related.

We use an equilibrium framework to demonstrate that compliance regulation singles out special joint futures price dynamics.

Based on this result, we propose an arbitrage-free futures price model, and apply it to the pricing of spread options between EUAs and CERs.

Pauline Barrieu and Max Fehr