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.