Equilibrium Pricing of Contingent Claims in Tradable Permit Markets

We advance a model of the tradable permit market and derive a pricing formula for contingent claims traded in the market in a general equilibrium framework. It is shown that prices of such contingent claims exhibit significantly different properties from those in the ordinary financial markets. In particular, if the social cost function kinks at some level of abatement, the forward price, as well as the spot price, can be subject to the so-called price spike. However, this price-spike phenomenon can be weakened if a system of banking and borrowing is properly introduced