Environmental Finance
How Financial Derivatives Can Help to Mitigate Climate Change
In an effort to mitigate climate change, over 180 countries have
ratified the Kyoto Protocol to reduce greenhouse gases, including
carbon dioxide. A key part of the agreement requires the developed
countries to impose caps on carbon dioxide emissions. As currently
implemented in the European Union, each of more than 7000 companies
(such as electric utilities, oil refiners, steel manufacturers, and
paper producers) is subject individually to an emissions quota, in the
form of a certain number of ``allowances'' or ``permits'' allocated to
it by its national government. Each allowance gives the right to emit
one ton of CO2. By controlling the total number of allowances
awarded, and penalizing any companies that emit CO2 in excess of their
allowance, regulators can achieve reductions in emissions.
Emissions Trading
Suppose that, in the absence of pollutant caps, my power plant is
expected to emit 120 tons of CO2, and your factory is expected to emit
100 tons of CO2, in some specified time frame. But by issuing, for
example, only 90 allowances to me, and 75 allowances to you, the
regulator directs us to curb our emissions by 25%.
Suppose, however, that it is costly for my power plant to make that
reduction, and comparatively cheap for your factory to make that
reduction. (Maybe consumer demand for power from my plant is
unexpectedly high, while consumer demand for your factory's goods is
unexpectedly low. Or maybe the clean production technologies in your
industry are more cost-effective and readily implementable than the
clean technologies in my industry.)
Suppose that, therefore, despite having to pay a stiff penalty for
exceeding my 90 allowances, I will operate my power plant at a level
that emits 95 tons of CO2. You are able to meet your quota, by
emitting only 75 tons of CO2; you could even go lower, at a small
nonzero cost, but in the absence of any incentive to go lower, you
will emit 75 tons.
What helps companies to meet the burdens of emissions reduction, while
maintaining the overall emission targets, is the existence of markets
for the trading of emissions allowances. If you sell me 5 of
your allowances, we can have a win-win situation. I will have 95
allowances, so I benefit by avoiding a stiff penalty payment to the
regulator. You will have only 70 allowances, but you benefit, because
the payment from me to you can finance your relatively cheap cost of
reducing your CO2 output from 75 to 70.
Finally, the environment benefits from the trade in both a direct and
indirect way. The direct benefit is that without trading, the total
emissions would be reduced to 95+75, whereas with trading, the total
emission is reduced to 95+70. The indirect benefit is that the easier
it is for companies to comply with emissions targets, the lower those
targets can be set without crippling the businesses.
Derivatives on Emissions Allowances
The majority of emissions trades do not involve the ``spot market''
(trading of the actual emissions allowances), but rather financial
derivatives (forwards, futures, and options) on those
allowances. In a forward contract between a buyer and seller
enter, the delivery of the emissions allowance, and the agreed payment
for it, do not occur immediately after the trade date, but rather on
some agreed maturity date in the future. An option to buy an
emissions allowance confers the holder the right, but not the
obligation, to buy an emissions allowance on some future maturity date
at some agreed strike price.
Introduction of derivatives brings several benefits.
- 1. Liquidity: If I want to buy some number of emissions allowances,
it may be difficult for me to find an industrial operator who is
currently willing to selling that number of allowances to me, at an
acceptable price. But with a forward/futures market, financial
institutions (such as banks and hedge funds) can step in and sell me,
for future delivery, the emissions allowances at market prices (even
if the financial institution does not own the underlying allowances).
- 2. Price discovery: With more activity and smaller transaction costs
than the spot markets, the derivatives markets facilitate revelation
of the implied cost of each ton of emissions. This helps business to
plan their activities in accordance with those costs, and it gives
clear incentives for engineers to develop environmentally friendly
technologies.
- 3. Risk management Derivatives facilitate the transfer of risk from
those who don't want to bear it to those who do. For example, suppose
that, depending on consumer demand, my power plant may or may not need
extra allowances in the future. Buying a call option on the
allowances provides insurance in the sense that the option guarantees
that the emissions allowances will not cost me more than the option's
pre-determined strike price.
Why Do Math
Mathematics plays an essential role in understanding how to price the
emissions derivatives and how to hedge their risks. Thereby it helps
financial institutions to buy and sell these products in markets such
as the European Climate Exchange and the Chicago Climate Exchange. As
discussed above, the trading in these products helps
greenhouse-gas-emitting companies to comply with emissions
regulations, and helps ensure that overall greenhouse gas targets are
met or lowered.
