Carbon emission permit price volatility reduction through financial options

- Marketable carbon permits can provide a low-social-cost approach for meeting carbon emission reduction targets.
- Volatility in carbon markets can undermine their effectiveness and viability.
- Trading of emissions permit options bundles can reduce carbon price volatility and the carbon spot price level.
- Carbon emission permit options provide an alternative to carbon price floors and ceilings.
- Options incentivize reductions by unregulated sources, and reduce the total discounted cost of carbon emission reductions.

We develop a stylized model to investigate the impact of financial options on reducing carbon permit price volatility under a cap-and-trade system. The existence of an option market provides a mechanism to hedge the uncertainty of future spot prices and is a stimulus for investment in carbon emission abatement technologies. We show that both the spot price level and the price volatility of carbon permits can be reduced via the trading of financial options, while achieving the emission reduction target. We also show that introducing financial options in a banking environment offers more flexibility to risk management in carbon permit trading.