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The existence of mandatory emission trading schemes in Europe and the United States, and the increased liquidity of trading on futures contracts on COz emissions allowances, led naturally to the next step in the development of these markets: These futures contracts are now used as underliers for a vibrant derivative market. In this paper, we give a rigorous analysis of a simple risk-neutral reduced-form model for allowance futures prices, demonstrate its calibration to historical data, and show how to price European call options written on these contracts. Key words: emission derivatives; emissions markets; cap-and-trade schemes; environmental finance History: Received April 25, 2009; accepted March 7, 2011, by Haitao Li, guest editor, finance. Published online in Articles in Advance June 20, 2011., 1. Introduction Global warming and environmental problems continue to challenge policy makers. In part because of the success of the U.S. Acid Rain Program, cap-and-trade systems are now considered to [...]

To link to full-text access for this article, visit this link: http://dx.doi.org/10.1016/j.ejor.2009.01.067 Byline: Jorg Doege (a), Max Fehr (b), Juri Hinz (c), Hans-Jakob Luthi (b), Martina Wilhelm (b) Keywords: Electricity risk; Power derivatives; Dispatch management of power plants; Operational flexibility; Futures markets; Emission trading Abstract: Since the 1990s power markets are being restructured worldwide and nowadays electrical power is traded as a commodity. The liberalization and with it the uncertainty in gas, fuel and electrical power prices requires an effective management of production facilities and financial contracts. Thereby derivatives build essential instruments to exchange volume as well as price risks. The challenge for participants in the newly competitive market environment is how to design, price and hedge derivative contracts in particular combination with the flexibility embedded in dispatch strategies of production assets. Accordingly, an adequate basis for management and investment decisions is needed which responds to the highly complex market situation. Author Affiliation: (a) McKinsey and Company, Inc., Taunustor 2, 60311 Frankfurt, Germany (b) Institute for Operations Research, ETH Zentrum, CH-8092 Zurich, Switzerland (c) National University of Singapore, Department of Mathematics, 2 Science Drive, 117543 Singapore, Singapore Article History: Received 30 November 2007; Accepted 31 January 2009