Electronic Thesis and Dissertation Repository

Degree

Doctor of Philosophy

Program

Applied Mathematics

Supervisor

Dr. Matt Davison

Abstract

New regulatory frameworks have been developed with the aim of decreasing global greenhouse gas emissions over both short and long time periods. Incentives must be established to encourage the transition to a clean energy economy. Emissions taxes represent a "price" incentive for this transition, but economists agree this approach is suboptimal. Instead, the "quantity" instrument provided by cap-and-trade markets are superior from an economic point of view. This thesis focuses on the cap-and-trade instrument. Carbon emissions markets have recently been implemented in different countries. We summarize the state of world cap-and-trade schemes. We also provide a literature review of existing research that offer pricing and hedging tools.

Based on the European Union Emissions Trading Scheme, we study the impact of the market design on the observed spread between futures contracts with different maturities. Moreover we investigate the relationship between their returns. First we study the spread using a discrete-time model. We propose a pricing procedure arising from quadratic risk minimization hedging strategies. We suggest recommendations for both traders and the regulator in order to efficiently encourage market participation.

We also present a continuous-time model that investigates the way in which the market structure affects the impact of an unexpected release of information on futures returns. We propose a pricing solution based on the Follmer-Schweizer decomposition. The optimal hedging strategy depends on all traded futures and minimizes the mean conditional square error of the cumulative cost process. Both discrete and continuous time model parameters are estimated to fit real data, and economic conclusions are drawn.


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