Empirical performance of reduced-form models for emission permit prices

The value of emission permits in environmental markets derives from the particular design features of the underlying cap-and-trade system. In this paper, we evaluate a model framework for the price dynamics of emission permits which accounts for these features in a reduced-form way. Based on permit futures and option data from the European Union Emissions Trading System, the world’s largest environmental market, we show that model variants which represent the design of the system most accurately provide the best fit to historical futures prices and achieve the best option pricing performance. Our results suggest that the specific design of cap-and-trade systems directly translates to the dynamic properties of emission permit prices, and that models tailored to environmental markets are the best choice for related pricing and risk management decisions.