Cap-and-trade

Properties under
Different Hybrid
Scheme Designs
Luca Taschini
London School of
Economics
Market for Permits
EU ETS
The Motivation
Ordinary Scheme
Price Floor
Price Collar
Allowance Reserve
Decomposition
Plain Options
Conclusions
References
Banking and
Borrowing
Cap-and-trade Properties under Different
Hybrid Scheme Designs
Luca Taschini
London School of Economics
Co-author: Georg Gr¨ ull (Uni. Duisburg-Essen)
1st European Colloquium of Environmental Finance,
Paris School of Economics - September 15th, 2010
1 / 25
Cap-and-trade
Properties under
Different Hybrid
Scheme Designs
Luca Taschini
London School of
Economics
Market for Permits
EU ETS
The Motivation
Ordinary Scheme
Price Floor
Price Collar
Allowance Reserve
Decomposition
Plain Options
Conclusions
References
Banking and
Borrowing
Marketable emission permits

Economists introduced market–based instruments in order to
provide incentives to reduce emissions.

In contrast to command–and–control, under marketable permits
regulated companies are free to decide how much they want to
emit or to abate.

The most commonly used market–based instruments are emission
taxes, subsidies on abatement of emissions, and tradable permits.

Under permits, a regulated firm must hold one permit for each
unit of pollution it emits.

When non-compliant, a penalty is levied for each uncovered unit of
a pollutant.

Firms can trade unused permits with other regulated firms (spatial
flexibility). These systems are called cap-&-trade schemes.

Under competitive conditions, market–based instruments lead to
equalization of marginal abatement costs across regulated
companies, a necessary condition for achieving an aggregate
emission target at minimal costs.
2 / 25
Cap-and-trade
Properties under
Different Hybrid
Scheme Designs
Luca Taschini
London School of
Economics
Market for Permits
EU ETS
The Motivation
Ordinary Scheme
Price Floor
Price Collar
Allowance Reserve
Decomposition
Plain Options
Conclusions
References
Banking and
Borrowing
Cap-&-trade schemes
The Regulator:

Allocates permits (for allocation criteria see
Aihman and Zetterberg [2005]);

Set the non-compliance penalty and enforce the
verification and monitoring procedures
(enforcement structure).
Regulated firms: Attempt to achieve compliance by

abating emission (adoption of low-emitting
technology, modification of the production process,
technology innovation);

trading emission permits (spot and futures
contracts).
Examples: There are several markets in operation

The ”Acid Rain Program” in the U.S. (sets a
national cap on SO
2
);

The European and UK Emission Trading Schemes
(EU ETS and UK ETS set caps on CO
2
);
And few more are under discussion

The New Zealand ETS, Canadian ETS, Australian
ETS and the Japanese ETS.
3 / 25
Cap-and-trade
Properties under
Different Hybrid
Scheme Designs
Luca Taschini
London School of
Economics
Market for Permits
EU ETS
The Motivation
Ordinary Scheme
Price Floor
Price Collar
Allowance Reserve
Decomposition
Plain Options
Conclusions
References
Banking and
Borrowing
The historical price of permits in the EU ETS
20ïAprï2005 06ïFebï2007 24ïNovï2008 12ïSepï2010
0
5
10
15
20
25
30
35
P
r
i
c
e


EUA Dec2012
EUA Spot Phase I
Possible undesirable scenarios in an ordinary (unconstrained)
scheme are:

Too low permit price (insufficient signal to induce technology
change);

Too high permit price (unnecessary high compliance costs).
4 / 25
Cap-and-trade
Properties under
Different Hybrid
Scheme Designs
Luca Taschini
London School of
Economics
Market for Permits
EU ETS
The Motivation
Ordinary Scheme
Price Floor
Price Collar
Allowance Reserve
Decomposition
Plain Options
Conclusions
References
Banking and
Borrowing
Motivation of our paper
Aim: The aim of this paper is to investigate the key
design features of existing and proposed
price-containment mechanisms.
Approach: We first introduce a stylized version of the
stochastic equilibrium price of emission permits.
Then, we derive the permit price dynamics under
five different alternative hybrid schemes:

price floor using a minimum price guarantee;

price collar;

allowance reserve;

standard options offered by the regulator;

offsets relaxation (not discussed here).
5 / 25
Cap-and-trade
Properties under
Different Hybrid
Scheme Designs
Luca Taschini
London School of
Economics
Market for Permits
EU ETS
The Motivation
Ordinary Scheme
Price Floor
Price Collar
Allowance Reserve
Decomposition
Plain Options
Conclusions
References
Banking and
Borrowing
The paper in a nutshell

We quantify and discuss advantages and disadvantages of the
proposed hybrid schemes by investigating whether pre-set
objectives can be accomplished while maintaining the original
environmental targets. In particular, we systematically
compare:

the enforcement of permit price bounds;

the expected compliance costs (measured as the sum of
abatement costs and the costs of allowance purchases) for
regulated companies;

the original environmental target;

and the regulator’s burden.

Each hybrid system under investigation can be decomposed
into a combination of:
An ordinary cap-and-trade scheme
+
(Un)limited amount of European- or American-style call and/or
put options.
6 / 25
Cap-and-trade
Properties under
Different Hybrid
Scheme Designs
Luca Taschini
London School of
Economics
Market for Permits
EU ETS
The Motivation
Ordinary Scheme
Price Floor
Price Collar
Allowance Reserve
Decomposition
Plain Options
Conclusions
References
Banking and
Borrowing
Ordinary cap-and-trade scheme
Let us define P as the penalty that has to be paid at compliance date
T. Also, N is the total amount of permits allocated to relevant
companies, i.e. the cap. Both P and N are known values.
We introduce a stylized version of the equilibrium price formula of
Seifert et al. [2008], Chesney and Taschini [2009] and Carmona et al.
[2009]:
F(t, T) = P · P
`
q
[0,T]
> N|F
t
´
, (1)
where the stochastic (and endogenous) process q
[0,T]
measures
emissions and abatements. In particular, this process depends on the
penalty level, the available abatement alternatives and their costs.
After abatement reductions, P
`
q
[0,T]
> N|F
t
´
measures the probability
of the total amount of emissions exceeding the initial amount of
permits.
This stylized version expresses the permit price in terms of the demand
(q
[0,t]
) and supply (N) of permits, and the enforcement level (P). In
what follows, F(t, T) refers to the permit price in the ordinary system.
7 / 25
Cap-and-trade
Properties under
Different Hybrid
Scheme Designs
Luca Taschini
London School of
Economics
Market for Permits
EU ETS
The Motivation
Ordinary Scheme
Price Floor
Price Collar
Allowance Reserve
Decomposition
Plain Options
Conclusions
References
Banking and
Borrowing
Price floor using a minimum price guarantee
Mechanism

At compliance date, similar to situations involving an ordinary
scheme, a regulated firm with a permit shortage faces a
penalty P.

In contrast, when a company ends up with an excess of
permits, it receives a minimum price S (0 < S < P) per unit
of permit.
Scheme decomposition
In this hybrid system the futures permit price,
˜
F(t, T), is
˜
F(t, T) = P · P

q
[0,T]
> N | F
t

+ S · P

q
[0,T]
≤ N | F
t

= F(t, T) + S

1 −
F(t, T)
P

.
This hybrid scheme corresponds to an ordinary system and a
limited amount of European put options with strike price S.
8 / 25
Cap-and-trade
Properties under
Different Hybrid
Scheme Designs
Luca Taschini
London School of
Economics
Market for Permits
EU ETS
The Motivation
Ordinary Scheme
Price Floor
Price Collar
Allowance Reserve
Decomposition
Plain Options
Conclusions
References
Banking and
Borrowing
Price floor: the expected compliance cost
Let us define f
q
as the probability density function of q
[0,T]
,
i.e. the sum of abatements and emissions over the entire regulated
period.
The expected compliance cost (measured as the sum of abatement
costs and the costs of allowance purchases) for regulated
companies in this hybrid system is:
ECC
PF
=
ECC ordinary system
. .. .
P


N
(x − N)f
q
(x)dx −S

N
0
(N − x)f
q
(x)dx
. .. .
hybrid system
where x is the final total amount of non-offset emissions. Because
ECC − ECC
PF
= S

N
0
(N − x)f
q
(x)dx ≥ 0.
the total expected compliance costs under this hybrid system are
lower than under an ordinary system.
9 / 25
Cap-and-trade
Properties under
Different Hybrid
Scheme Designs
Luca Taschini
London School of
Economics
Market for Permits
EU ETS
The Motivation
Ordinary Scheme
Price Floor
Price Collar
Allowance Reserve
Decomposition
Plain Options
Conclusions
References
Banking and
Borrowing
Price floor: advantages and disadvantages
Price bounds: The presence of a minimum price guarantee
provides an effective price floor that equals S.
Uncertainty: The price floor reduces the permit price volatility
at the expenses of some variation in the quantity
of outstanding permits.
ECC: The expected compliance costs for relevant
companies are lower than under an ordinary
system. The reduction depends on the S level.
Env. target: The original environmental target is unaffected.
Regulator: The implementation of such a hybrid system might
result in a significant financial burden whose
magnitude is hardly quantifiable a priori.
10 / 25
Cap-and-trade
Properties under
Different Hybrid
Scheme Designs
Luca Taschini
London School of
Economics
Market for Permits
EU ETS
The Motivation
Ordinary Scheme
Price Floor
Price Collar
Allowance Reserve
Decomposition
Plain Options
Conclusions
References
Banking and
Borrowing
“Hard” price collar
Mechanism

Similar to situations involving an ordinary scheme, a company
with a permit shortage at compliance date faces a penalty P

p
max
is the price ceiling, i.e. the price at which the policy
regulator sells an unlimited amount of permits;

p
min
is the price floor, i.e. the price at which the policy
regulator buys an unlimited amount of permits.
Scheme decomposition
This hybrid scheme can be decomposed into a combination of

an ordinary scheme,

an unlimited amount of American call options with strike
price p
max
,

an unlimited amount of American put options with strike
price p
min
.
11 / 25
Cap-and-trade
Properties under
Different Hybrid
Scheme Designs
Luca Taschini
London School of
Economics
Market for Permits
EU ETS
The Motivation
Ordinary Scheme
Price Floor
Price Collar
Allowance Reserve
Decomposition
Plain Options
Conclusions
References
Banking and
Borrowing
Price collar: three possible situations

Let N
t−
and N
t
be, respectively, the amount of outstanding
permits before (t−) and after (t) the intervention of the policy
regulator on the market for permits.

Let α
t
= N
t
−N
t−
denote the amount of permits added (α
t
> 0)
or subtracted (α
t
< 0) to the market at time t.
There are three possible situations:
1. If the permit price is between the price collar,
F(t, T) ∈ (p
min
, p
max
), than there is no market intervention and
α
t
= 0.
2. If the permit price exceeds p
max
:

Regulated companies that buy permits at the price ceiling are in
fact exercising American call options with a strike p
max
.

Relying on standard arbitrage arguments, the theoretical amount
of permits α
t
> 0 that drives the market price of permits back to
p
max
is:
P · P
`
q
[0,T]
> N
t−

t
|F
t
´
= p
max
α
t
is unknown prior to compliance time as regulated companies will
never exercise the American call option before maturity.
12 / 25
Cap-and-trade
Properties under
Different Hybrid
Scheme Designs
Luca Taschini
London School of
Economics
Market for Permits
EU ETS
The Motivation
Ordinary Scheme
Price Floor
Price Collar
Allowance Reserve
Decomposition
Plain Options
Conclusions
References
Banking and
Borrowing
Price collar: three possible situations
3. If the permit price drops below p
min
:

Regulated companies that sell permits at the price ceiling are in
fact exercising American put options with a strike p
min
.

Relying on standard arbitrage arguments, the theoretical amount
of permits α
t
< 0 that drives the market price of permits back to
p
min
is:
P · P
`
q
[0,T]
> N
t−

t
|F
t
´
= p
min
Because regulated companies do not physically need the permits to
produce and, more importantly, they have to achieve compliance only at
one time, companies will never exercise the American put option before
maturity. Again α
t
is unknown prior to compliance time.
13 / 25
Cap-and-trade
Properties under
Different Hybrid
Scheme Designs
Luca Taschini
London School of
Economics
Market for Permits
EU ETS
The Motivation
Ordinary Scheme
Price Floor
Price Collar
Allowance Reserve
Decomposition
Plain Options
Conclusions
References
Banking and
Borrowing
Price collar: advantages and disadvantages
Price bounds: This mechanism is extremely effective in
guaranteeing a pre-set price range.
Uncertainty: Blending in with expectations on emissions and
abatement, the extra stochastic factor α
t
enhances
uncertainty on the supply side. This scheme
trades off price volatility for a more uncertain cap
level.
ECC: The expected compliance costs for relevant
companies are lower than under an ordinary system.
Env. target: The original environmental target is severely
loosen (if price hits p
max
).
Regulator: If price hits p
min
, the financial burden for the
regulator is significant and hardly quantifiable a
priori.
14 / 25
Cap-and-trade
Properties under
Different Hybrid
Scheme Designs
Luca Taschini
London School of
Economics
Market for Permits
EU ETS
The Motivation
Ordinary Scheme
Price Floor
Price Collar
Allowance Reserve
Decomposition
Plain Options
Conclusions
References
Banking and
Borrowing
Allowance reserve
Mechanism

Similar to situations involving an ordinary scheme, a company
with a permit shortage at compliance date faces a penalty P

p
max
is the price ceiling, i.e. the price at which the policy
regulator sells a limited amount of permits, η = (N
max
− N);
Scheme decomposition
This hybrid scheme can be decomposed into a combination of

an ordinary scheme,

a limited amount of American call options with strike price
p
max
.
15 / 25
Cap-and-trade
Properties under
Different Hybrid
Scheme Designs
Luca Taschini
London School of
Economics
Market for Permits
EU ETS
The Motivation
Ordinary Scheme
Price Floor
Price Collar
Allowance Reserve
Decomposition
Plain Options
Conclusions
References
Banking and
Borrowing
Allowance reserve: the expected compliance cost
As before, let f
q
be the probability density function of q
[0,T]
,
i.e. the sum of abatements and emissions over the entire regulated
period.
The expected compliance cost of this hybrid scheme is lower than
the one in an ordinary system:
ECC − ECC
AR
= (P − p
max
)

N+η
N
(x − N)f
q
(x)dx ≥ 0,
where x is the final total amount of non-offset emissions.
Letting P
c
be the price of an American call option with strike
price p
max
and relying on the fact that P
c
≤ P − p
max
,
ECC − ECC
AR
≥ P
c

N+η
N
(x − N)f
q
(x)dx
is a lower bound. The smaller the price ceiling, the lower the
expected compliance costs of this hybrid system. Conversely, and
unsurprisingly, ECC
AR
= ECC when p
max
equals the penalty level
P.
16 / 25
Cap-and-trade
Properties under
Different Hybrid
Scheme Designs
Luca Taschini
London School of
Economics
Market for Permits
EU ETS
The Motivation
Ordinary Scheme
Price Floor
Price Collar
Allowance Reserve
Decomposition
Plain Options
Conclusions
References
Banking and
Borrowing
Allowance Reserve: advantages and disadvant.
Price bounds: The major disadvantage is its inability to
guarantee the price ceiling once the reserve has
been completely exploited.
Uncertainty: Due to the constrained ability of the policy
regulator to modify the level of the cap, this hybrid
scheme is a limited device to control the permit
price volatility.
ECC: The expected compliance cost for relevant
companies is lower than under an ordinary system.
Env. target: The original environmental target is partially
affected.
Regulator: This mechanism comes with no extra-costs.
17 / 25
Cap-and-trade
Properties under
Different Hybrid
Scheme Designs
Luca Taschini
London School of
Economics
Market for Permits
EU ETS
The Motivation
Ordinary Scheme
Price Floor
Price Collar
Allowance Reserve
Decomposition
Plain Options
Conclusions
References
Banking and
Borrowing
Mechanisms decomposition
All the hybrid systems investigated can be decomposed into an
ordinary cap-and-trade scheme combined with

an unlimited amount of European-style put options (price
floor with a minimum price guarantee);

an unlimited amount of American-style call and put options
(price collar);

a limited amount of American-style call options (allowance
reserve).
Therefore, by offering standard American and/or European options
at the beginning of the compliance period, a policy regulator can
replicate the results enforced by a minimum price guarantee, or a
price collar, or an allowance reserve reconciling the otherwise
conflicting policy objectives.
The idea to introduce options contracts has been initially proposed
by Unold and Requate [2001], although they do not specify the
type of options under discussion.
18 / 25
Cap-and-trade
Properties under
Different Hybrid
Scheme Designs
Luca Taschini
London School of
Economics
Market for Permits
EU ETS
The Motivation
Ordinary Scheme
Price Floor
Price Collar
Allowance Reserve
Decomposition
Plain Options
Conclusions
References
Banking and
Borrowing
Plain options: advantages and disadvantages
Price bounds: This mechanism limits the price exposure
exclusively of those companies that purchase
options.
Uncertainty: Implementing this mechanism does not add
uncertainty about the level of the cap or the
amount of outstanding permits.
ECC: The use of such ad hoc instruments gives
companies the opportunity to make the scheme
adaptable to their company-specific abatement
alternatives.
Env. target: By writing and hedging call options, the regulator
does not create extra allowances. Therefore, the
original environmental target is unaffected.
Regulator: Under the assumption that the regulator offers the
options at a fair market price, the expenses borne
by the regulator to implement this scheme are zero,
as concluded by Unold and Requate [2001].
19 / 25
Cap-and-trade
Properties under
Different Hybrid
Scheme Designs
Luca Taschini
London School of
Economics
Market for Permits
EU ETS
The Motivation
Ordinary Scheme
Price Floor
Price Collar
Allowance Reserve
Decomposition
Plain Options
Conclusions
References
Banking and
Borrowing
Conclusions
Using a stylized equilibrium permit price, we analyze four different
price-containment mechanisms and discuss the resulting scheme
decomposition.
In particular, we investigate their impact on the permit price
range:

Permit price bounds can be always guaranteed in a hybrid
system with a minimum price or in a system with a “hard”
price collar.

A system where the regulator sells options to regulated
companies guarantees price bounds for those companies
that are willing to pay for such a protection.

The other system under study (allowance reserve) cannot
guarantee that the permit price will be capped under all
possible circumstances.
20 / 25
Cap-and-trade
Properties under
Different Hybrid
Scheme Designs
Luca Taschini
London School of
Economics
Market for Permits
EU ETS
The Motivation
Ordinary Scheme
Price Floor
Price Collar
Allowance Reserve
Decomposition
Plain Options
Conclusions
References
Banking and
Borrowing
Conclusions
ECC: We show that all proposed hybrid systems reduce
the expected compliance costs for relevant
companies.
Regulator: By implementing these schemes the regulator faces

substantial costs (price collar),

limited costs (price floor),

or no-costs at all (allowance reserve, plain
options, offsets relaxation).
Target: At the same time, the original environmental
targets are

severely loosened (price collar),

downsized (allowance reserve),

or unaffected (price floor, plain options).
21 / 25
Cap-and-trade
Properties under
Different Hybrid
Scheme Designs
Luca Taschini
London School of
Economics
Market for Permits
EU ETS
The Motivation
Ordinary Scheme
Price Floor
Price Collar
Allowance Reserve
Decomposition
Plain Options
Conclusions
References
Banking and
Borrowing
References I
M. Aihman and L. Zetterberg. Options for emission allowance
allocation under the eu emissions trading directive. Mitigation
and Adaptation Strategies for Global Change, 10:597–645,
2005.
R. Carmona, M. Fehr, J. Hinz, and A. Porchet. Market design for
emission trading schemes. SIAM Review, 9(3):465–469, 2009.
M. Chesney and L. Taschini. The endogenous price dynamics of
emission permits in the presence of technology change.
Grantham Research Institute, London School of Economics -
UK., 2009.
G. Gr¨ ull and L. Taschini. Cap-and-trade Properties under Different
Hybrid Scheme Designs. Journal of Environmental Economics
and Management - forthcoming.
J. Seifert, M. Uhrig-Homburg, and M. Wagner. Dynamic behavior
of CO
2
spot prices. Journal of Environmental Economics and
Managements, 56:180–194, 2008.
W. Unold and T. Requate. Pollution control by options trading.
Economics Letters, 73:353–358, 2001.
22 / 25
Cap-and-trade
Properties under
Different Hybrid
Scheme Designs
Luca Taschini
London School of
Economics
Market for Permits
EU ETS
The Motivation
Ordinary Scheme
Price Floor
Price Collar
Allowance Reserve
Decomposition
Plain Options
Conclusions
References
Banking and
Borrowing
Ordinary scheme with banking and borrowing
Setup of the n-period model

Regulated companies have to comply at the end of each
compliance period {i , i = 1, . . . , n} (hereafter i -th period).

A regulated company that does not comply at time T
i
has to

pay a penalty P
(i )
and

surrender the missing permit using its allocation for the
next compliance period.

Regulated companies have the opportunity to bank unused
permits into the next period.

A company that does not comply at time T
n
has to pay the
penalty P
(n)
. All unused allowances have no redemption
value after T
n
.
23 / 25
Cap-and-trade
Properties under
Different Hybrid
Scheme Designs
Luca Taschini
London School of
Economics
Market for Permits
EU ETS
The Motivation
Ordinary Scheme
Price Floor
Price Collar
Allowance Reserve
Decomposition
Plain Options
Conclusions
References
Banking and
Borrowing
Ordinary scheme with banking and borrowing
Recalling that E[F(T
2
, T
2
) | F
t
] = F(t, T
2
), i.e. futures are
martingales, we can show that the price at time t ≤ T
1
of the
permit valid for compliance in the current compliance period is
F(t, T
1
) = P
(1)
P

q
[0,T
1
]
> N
(1)
| F
t

(2)
+
n
¸
j =2
e
−r (T
j
−T
1
)
P
(j )
P

j
¸
k=1
q
[T
k−1
,T
k
]
>
j
¸
k=1
N
(k)
| F
t

. .. .
B
t
,
where

r is the interest rate;

q
[T
i −1
,T
i
]
measures the emissions in the i-th period net of
abatement reductions;

N
(i )
denotes the amount of allocated permits in the i-th
period (between T
i −1
and T
i
);

and T
0
= 0.
24 / 25
Cap-and-trade
Properties under
Different Hybrid
Scheme Designs
Luca Taschini
London School of
Economics
Market for Permits
EU ETS
The Motivation
Ordinary Scheme
Price Floor
Price Collar
Allowance Reserve
Decomposition
Plain Options
Conclusions
References
Banking and
Borrowing
Ordinary scheme with banking and borrowing
Permit price properties

The permit price can be decomposed into two components:

the expected value of compliance in the current compliance
period.

the expected banking and borrowing values implied in the
permit price (denoted by B
t
).

B
t
can be broken down into several values of banking
(borrowing) the permit into (from) one of the consecutive
periods.
Therefore, B
t
measures the value of the consecutive
opportunities to bank/borrow starting from the current
compliance period.
Hybrid schemes with banking and limited borrowing
Using this extended stylized model it can be shown that the
presence of banking, borrowing, and withdrawal does not alter our
results.
25 / 25

Marketable emission permits
Economists introduced market–based instruments in order to provide incentives to reduce emissions. In contrast to command–and–control, under marketable permits regulated companies are free to decide how much they want to emit or to abate. The most commonly used market–based instruments are emission taxes, subsidies on abatement of emissions, and tradable permits. Under permits, a regulated firm must hold one permit for each unit of pollution it emits. When non-compliant, a penalty is levied for each uncovered unit of a pollutant. Firms can trade unused permits with other regulated firms (spatial flexibility). These systems are called cap-&-trade schemes. Under competitive conditions, market–based instruments lead to equalization of marginal abatement costs across regulated companies, a necessary condition for achieving an aggregate emission target at minimal costs.

Cap-and-trade Properties under Different Hybrid Scheme Designs Luca Taschini London School of Economics Market for Permits EU ETS The Motivation Ordinary Scheme Price Floor Price Collar Allowance Reserve Decomposition Plain Options Conclusions References Banking and Borrowing

2 / 25

Canadian ETS.Cap-&-trade schemes The Regulator: Allocates permits (for allocation criteria see Aihman and Zetterberg [2005]). (sets a national cap on SO2 ).S. Cap-and-trade Properties under Different Hybrid Scheme Designs Luca Taschini London School of Economics Market for Permits EU ETS The Motivation Regulated firms: Attempt to achieve compliance by Ordinary Scheme Price Floor Price Collar Allowance Reserve Decomposition Plain Options Conclusions References Banking and Borrowing 3 / 25 . trading emission permits (spot and futures contracts). The European and UK Emission Trading Schemes (EU ETS and UK ETS set caps on CO2 ). Australian ETS and the Japanese ETS. And few more are under discussion The New Zealand ETS. technology innovation). modification of the production process. abating emission (adoption of low-emitting technology. Set the non-compliance penalty and enforce the verification and monitoring procedures (enforcement structure). Examples: There are several markets in operation The ”Acid Rain Program” in the U.

4 / 25 . Too high permit price (unnecessary high compliance costs).The historical price of permits in the EU ETS 35 EUA Dec2012 EUA Spot Phase I 30 Cap-and-trade Properties under Different Hybrid Scheme Designs Luca Taschini London School of Economics Market for Permits 25 EU ETS The Motivation 20 Price Ordinary Scheme 15 Price Floor Price Collar 10 Allowance Reserve Decomposition 5 Plain Options 0 20 Apr 2005 Conclusions 06 Feb 2007 24 Nov 2008 12 Sep 2010 References Banking and Borrowing Possible undesirable scenarios in an ordinary (unconstrained) scheme are: Too low permit price (insufficient signal to induce technology change).

Motivation of our paper Aim: The aim of this paper is to investigate the key design features of existing and proposed price-containment mechanisms. Approach: We first introduce a stylized version of the stochastic equilibrium price of emission permits. standard options offered by the regulator. allowance reserve. we derive the permit price dynamics under five different alternative hybrid schemes: price floor using a minimum price guarantee. offsets relaxation (not discussed here). Then. Cap-and-trade Properties under Different Hybrid Scheme Designs Luca Taschini London School of Economics Market for Permits EU ETS The Motivation Ordinary Scheme Price Floor Price Collar Allowance Reserve Decomposition Plain Options Conclusions References Banking and Borrowing 5 / 25 . price collar.

In particular.or American-style call and/or put options. References Banking and Borrowing 6 / 25 . Cap-and-trade Properties under Different Hybrid Scheme Designs Luca Taschini London School of Economics Market for Permits EU ETS The Motivation Ordinary Scheme Price Floor Price Collar Allowance Reserve Decomposition Plain Options Conclusions Each hybrid system under investigation can be decomposed into a combination of: An ordinary cap-and-trade scheme + (Un)limited amount of European. the expected compliance costs (measured as the sum of abatement costs and the costs of allowance purchases) for regulated companies. we systematically compare: the enforcement of permit price bounds. and the regulator’s burden. the original environmental target.The paper in a nutshell We quantify and discuss advantages and disadvantages of the proposed hybrid schemes by investigating whether pre-set objectives can be accomplished while maintaining the original environmental targets.

´ ` After abatement reductions. [2009]: ` ´ F (t.T ] > N|Ft measures the probability of the total amount of emissions exceeding the initial amount of permits. (1) where the stochastic (and endogenous) process q[0. T ) = P · P q[0. i. N is the total amount of permits allocated to relevant companies. [2008]. the available abatement alternatives and their costs.e.T ] > N|Ft . In what follows. P q[0. In particular. the cap. T ) refers to the permit price in the ordinary system. Also. We introduce a stylized version of the equilibrium price formula of Seifert et al. Both P and N are known values. and the enforcement level (P). this process depends on the penalty level.Ordinary cap-and-trade scheme Let us define P as the penalty that has to be paid at compliance date T . Chesney and Taschini [2009] and Carmona et al. F (t. This stylized version expresses the permit price in terms of the demand (q[0.T ] measures emissions and abatements.t] ) and supply (N) of permits. Cap-and-trade Properties under Different Hybrid Scheme Designs Luca Taschini London School of Economics Market for Permits EU ETS The Motivation Ordinary Scheme Price Floor Price Collar Allowance Reserve Decomposition Plain Options Conclusions References Banking and Borrowing 7 / 25 .

is ˜ F (t. similar to situations involving an ordinary scheme. 8 / 25 . T ) + S 1 − F (t.Price floor using a minimum price guarantee Mechanism At compliance date.T ] ≤ N | Ft = F (t. T ) P . Cap-and-trade Properties under Different Hybrid Scheme Designs Luca Taschini London School of Economics Market for Permits EU ETS The Motivation Ordinary Scheme Price Floor Price Collar Allowance Reserve Scheme decomposition ˜ In this hybrid system the futures permit price. T ). F (t. In contrast. T ) = P · P q[0. Decomposition Plain Options Conclusions References Banking and Borrowing This hybrid scheme corresponds to an ordinary system and a limited amount of European put options with strike price S. a regulated firm with a permit shortage faces a penalty P. it receives a minimum price S (0 < S < P) per unit of permit.T ] > N | Ft + S · P q[0. when a company ends up with an excess of permits.

Because N ECC − ECC PF = S 0 (N − x)fq (x)dx ≥ 0.T ] . 9 / 25 . the sum of abatements and emissions over the entire regulated period. The expected compliance cost (measured as the sum of abatement costs and the costs of allowance purchases) for regulated companies in this hybrid system is: ECC ordinary system ∞ N Cap-and-trade Properties under Different Hybrid Scheme Designs Luca Taschini London School of Economics Market for Permits EU ETS The Motivation Ordinary Scheme Price Floor Price Collar Allowance Reserve ECC PF = P N (x − N)fq (x)dx −S 0 (N − x)fq (x)dx Decomposition Plain Options Conclusions References Banking and Borrowing hybrid system where x is the final total amount of non-offset emissions. the total expected compliance costs under this hybrid system are lower than under an ordinary system. i.Price floor: the expected compliance cost Let us define fq as the probability density function of q[0.e.

Uncertainty: The price floor reduces the permit price volatility at the expenses of some variation in the quantity of outstanding permits. target: The original environmental target is unaffected. Regulator: The implementation of such a hybrid system might result in a significant financial burden whose magnitude is hardly quantifiable a priori. The reduction depends on the S level. Market for Permits EU ETS The Motivation Ordinary Scheme Price Floor Price Collar Allowance Reserve Decomposition Plain Options Conclusions References Banking and Borrowing 10 / 25 . Env. ECC: The expected compliance costs for relevant companies are lower than under an ordinary system.Price floor: advantages and disadvantages Cap-and-trade Properties under Different Hybrid Scheme Designs Luca Taschini London School of Economics Price bounds: The presence of a minimum price guarantee provides an effective price floor that equals S.

an unlimited amount of American call options with strike price p max .e. Plain Options Conclusions References Banking and Borrowing 11 / 25 . i. an unlimited amount of American put options with strike price p min . i. the price at which the policy regulator buys an unlimited amount of permits.e.“Hard” price collar Mechanism Similar to situations involving an ordinary scheme. the price at which the policy regulator sells an unlimited amount of permits. p min is the price floor. Cap-and-trade Properties under Different Hybrid Scheme Designs Luca Taschini London School of Economics Market for Permits EU ETS The Motivation Ordinary Scheme Price Floor Price Collar Allowance Reserve Decomposition Scheme decomposition This hybrid scheme can be decomposed into a combination of an ordinary scheme. a company with a permit shortage at compliance date faces a penalty P p max is the price ceiling.

than there is no market intervention and αt = 0. If the permit price is between the price collar. F (t. 2.Price collar: three possible situations Let Nt− and Nt be. the amount of outstanding permits before (t−) and after (t) the intervention of the policy regulator on the market for permits. Relying on standard arbitrage arguments. Cap-and-trade Properties under Different Hybrid Scheme Designs Luca Taschini London School of Economics Market for Permits EU ETS The Motivation Ordinary Scheme Price Floor Price Collar Allowance Reserve Decomposition Plain Options Conclusions References Banking and Borrowing 12 / 25 .T ] > Nt− + αt |Ft = p max αt is unknown prior to compliance time as regulated companies will never exercise the American call option before maturity. p max ). Let αt = Nt − Nt− denote the amount of permits added (αt > 0) or subtracted (αt < 0) to the market at time t. respectively. There are three possible situations: 1. T ) ∈ (p min . the theoretical amount of permits αt > 0 that drives the market price of permits back to p max is: ` ´ P · P q[0. If the permit price exceeds p max : Regulated companies that buy permits at the price ceiling are in fact exercising American call options with a strike p max .

Market for Permits EU ETS The Motivation Ordinary Scheme Price Floor Price Collar Allowance Reserve Decomposition Plain Options Conclusions References Banking and Borrowing 13 / 25 .Price collar: three possible situations Cap-and-trade Properties under Different Hybrid Scheme Designs Luca Taschini London School of Economics 3.T ] > Nt− + αt |Ft = p min Because regulated companies do not physically need the permits to produce and. Again αt is unknown prior to compliance time. Relying on standard arbitrage arguments. If the permit price drops below p min : Regulated companies that sell permits at the price ceiling are in fact exercising American put options with a strike p min . more importantly. companies will never exercise the American put option before maturity. the theoretical amount of permits αt < 0 that drives the market price of permits back to p min is: ´ ` P · P q[0. they have to achieve compliance only at one time.

the extra stochastic factor αt enhances uncertainty on the supply side. Uncertainty: Blending in with expectations on emissions and abatement.Price collar: advantages and disadvantages Price bounds: This mechanism is extremely effective in guaranteeing a pre-set price range. This scheme trades off price volatility for a more uncertain cap level. target: The original environmental target is severely loosen (if price hits p max ). the financial burden for the regulator is significant and hardly quantifiable a priori. ECC: The expected compliance costs for relevant companies are lower than under an ordinary system. min Cap-and-trade Properties under Different Hybrid Scheme Designs Luca Taschini London School of Economics Market for Permits EU ETS The Motivation Ordinary Scheme Price Floor Price Collar Allowance Reserve Decomposition Plain Options Conclusions References Banking and Borrowing 14 / 25 . Env. Regulator: If price hits p .

a company with a permit shortage at compliance date faces a penalty P p is the price ceiling. Plain Options Conclusions References Banking and Borrowing 15 / 25 .e. max Market for Permits EU ETS The Motivation Ordinary Scheme Price Floor Price Collar Allowance Reserve Decomposition Scheme decomposition This hybrid scheme can be decomposed into a combination of an ordinary scheme. η = (N max − N). a limited amount of American call options with strike price p max . i. the price at which the policy regulator sells a limited amount of permits.Allowance reserve Cap-and-trade Properties under Different Hybrid Scheme Designs Luca Taschini London School of Economics Mechanism Similar to situations involving an ordinary scheme.

i.e. the sum of abatements and emissions over the entire regulated period. Letting P c be the price of an American call option with strike price p max and relying on the fact that P c ≤ P − p max .T ] .Allowance reserve: the expected compliance cost As before. The expected compliance cost of this hybrid scheme is lower than the one in an ordinary system: N+η Cap-and-trade Properties under Different Hybrid Scheme Designs Luca Taschini London School of Economics Market for Permits EU ETS The Motivation Ordinary Scheme ECC − ECC AR = (P − p max ) N (x − N)fq (x)dx ≥ 0. ECC AR = ECC when p max equals the penalty level P. Conversely. N+η Decomposition Plain Options Conclusions References Banking and Borrowing ECC − ECC AR ≥ P c N (x − N)fq (x)dx is a lower bound. let fq be the probability density function of q[0. and unsurprisingly. 16 / 25 . The smaller the price ceiling. Price Floor Price Collar Allowance Reserve where x is the final total amount of non-offset emissions. the lower the expected compliance costs of this hybrid system.

ECC: The expected compliance cost for relevant companies is lower than under an ordinary system. Regulator: This mechanism comes with no extra-costs. target: The original environmental target is partially affected. Market for Permits EU ETS The Motivation Ordinary Scheme Price Floor Price Collar Allowance Reserve Decomposition Plain Options Conclusions References Banking and Borrowing 17 / 25 . Uncertainty: Due to the constrained ability of the policy regulator to modify the level of the cap. Env.Allowance Reserve: advantages and disadvant. this hybrid scheme is a limited device to control the permit price volatility. Cap-and-trade Properties under Different Hybrid Scheme Designs Luca Taschini London School of Economics Price bounds: The major disadvantage is its inability to guarantee the price ceiling once the reserve has been completely exploited.

a policy regulator can replicate the results enforced by a minimum price guarantee. although they do not specify the type of options under discussion. or an allowance reserve reconciling the otherwise conflicting policy objectives. an unlimited amount of American-style call and put options (price collar). The idea to introduce options contracts has been initially proposed by Unold and Requate [2001].Mechanisms decomposition All the hybrid systems investigated can be decomposed into an ordinary cap-and-trade scheme combined with an unlimited amount of European-style put options (price floor with a minimum price guarantee). Cap-and-trade Properties under Different Hybrid Scheme Designs Luca Taschini London School of Economics Market for Permits EU ETS The Motivation Ordinary Scheme Price Floor Price Collar Allowance Reserve Decomposition Plain Options Conclusions References Banking and Borrowing 18 / 25 . Therefore. by offering standard American and/or European options at the beginning of the compliance period. or a price collar. a limited amount of American-style call options (allowance reserve).

the original environmental target is unaffected. Cap-and-trade Properties under Different Hybrid Scheme Designs Luca Taschini London School of Economics Market for Permits EU ETS The Motivation Ordinary Scheme Price Floor Price Collar Allowance Reserve Decomposition Plain Options Conclusions References Banking and Borrowing 19 / 25 . the regulator does not create extra allowances.Plain options: advantages and disadvantages Price bounds: This mechanism limits the price exposure exclusively of those companies that purchase options. target: By writing and hedging call options. Therefore. ECC: The use of such ad hoc instruments gives companies the opportunity to make the scheme adaptable to their company-specific abatement alternatives. Env. the expenses borne by the regulator to implement this scheme are zero. as concluded by Unold and Requate [2001]. Uncertainty: Implementing this mechanism does not add uncertainty about the level of the cap or the amount of outstanding permits. Regulator: Under the assumption that the regulator offers the options at a fair market price.

In particular. Cap-and-trade Properties under Different Hybrid Scheme Designs Luca Taschini London School of Economics Market for Permits EU ETS The Motivation Ordinary Scheme Price Floor Price Collar Allowance Reserve Decomposition Plain Options Conclusions References Banking and Borrowing 20 / 25 . we analyze four different price-containment mechanisms and discuss the resulting scheme decomposition. we investigate their impact on the permit price range: Permit price bounds can be always guaranteed in a hybrid system with a minimum price or in a system with a “hard” price collar. The other system under study (allowance reserve) cannot guarantee that the permit price will be capped under all possible circumstances.Conclusions Using a stylized equilibrium permit price. A system where the regulator sells options to regulated companies guarantees price bounds for those companies that are willing to pay for such a protection.

offsets relaxation). the original environmental targets are severely loosened (price collar). Target: At the same time. or no-costs at all (allowance reserve. limited costs (price floor). plain options). Cap-and-trade Properties under Different Hybrid Scheme Designs Luca Taschini London School of Economics Market for Permits EU ETS The Motivation Ordinary Scheme Price Floor Price Collar Allowance Reserve Decomposition Plain Options Conclusions References Banking and Borrowing 21 / 25 .Conclusions ECC: We show that all proposed hybrid systems reduce the expected compliance costs for relevant companies. downsized (allowance reserve). Regulator: By implementing these schemes the regulator faces substantial costs (price collar). or unaffected (price floor. plain options.

Dynamic behavior of CO2 spot prices. J. Journal of Environmental Economics and Managements.. 73:353–358. Taschini. 56:180–194. Options for emission allowance allocation under the eu emissions trading directive. Carmona. 2009. Wagner. 2005.References I M. and A. Market design for emission trading schemes. G. and M. The endogenous price dynamics of emission permits in the presence of technology change. London School of Economics UK. Pollution control by options trading. Mitigation and Adaptation Strategies for Global Change. Requate. Zetterberg. SIAM Review. Gr¨ll and L. Cap-and-trade Properties under Different Hybrid Scheme Designs Luca Taschini London School of Economics Market for Permits EU ETS The Motivation Ordinary Scheme Price Floor Price Collar Allowance Reserve Decomposition Plain Options Conclusions References Banking and Borrowing 22 / 25 . 2008. Hinz.forthcoming. Fehr. Chesney and L. Cap-and-trade Properties under Different u Hybrid Scheme Designs. Economics Letters. Seifert. Unold and T. Grantham Research Institute. 2009. Porchet. Aihman and L. W. J. Taschini. 10:597–645. R. Journal of Environmental Economics and Management . M. 9(3):465–469. M. 2001. Uhrig-Homburg. M.

n} (hereafter i-th period). A company that does not comply at time Tn has to pay the penalty P (n) . A regulated company that does not comply at time Ti has to pay a penalty P and surrender the missing permit using its allocation for the next compliance period. . All unused allowances have no redemption value after Tn .Ordinary scheme with banking and borrowing Setup of the n-period model Regulated companies have to comply at the end of each compliance period {i. . . 23 / 25 . i = 1. . (i) Cap-and-trade Properties under Different Hybrid Scheme Designs Luca Taschini London School of Economics Market for Permits EU ETS The Motivation Ordinary Scheme Price Floor Price Collar Allowance Reserve Decomposition Plain Options Conclusions References Banking and Borrowing Regulated companies have the opportunity to bank unused permits into the next period.

T1 ] > N (1) | Ft n j j (2) q[Tk−1 . Conclusions References Banking and Borrowing 24 / 25 . T2 ) | Ft ] = F (t. q[Ti−1 . we can show that the price at time t ≤ T1 of the permit valid for compliance in the current compliance period is F (t. i. T1 ) = + j=2 Cap-and-trade Properties under Different Hybrid Scheme Designs Luca Taschini London School of Economics Market for Permits EU ETS P (1) P q[0. T2 ). futures are martingales.Ordinary scheme with banking and borrowing Recalling that E [F (T2 . and T0 = 0.e. k=1 Bt The Motivation Ordinary Scheme Price Floor Price Collar Allowance Reserve Decomposition Plain Options e −r (Tj −T1 ) P (j) P k=1 where r is the interest rate.Ti ] measures the emissions in the i-th period net of abatement reductions. N (i) denotes the amount of allocated permits in the i-th period (between Ti−1 and Ti ).Tk ] > N (k) | Ft .

Cap-and-trade Properties under Different Hybrid Scheme Designs Luca Taschini London School of Economics Market for Permits EU ETS The Motivation Ordinary Scheme Price Floor Price Collar Allowance Reserve Decomposition Plain Options Bt can be broken down into several values of banking (borrowing) the permit into (from) one of the consecutive periods. Therefore.Ordinary scheme with banking and borrowing Permit price properties The permit price can be decomposed into two components: the expected value of compliance in the current compliance period. the expected banking and borrowing values implied in the permit price (denoted by Bt ). and withdrawal does not alter our results. borrowing. Bt measures the value of the consecutive opportunities to bank/borrow starting from the current compliance period. Conclusions References Banking and Borrowing Hybrid schemes with banking and limited borrowing Using this extended stylized model it can be shown that the presence of banking. 25 / 25 .

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