Supply-Side Perspective for Carbon Pricing

This paper theoretically and empirically revisits carbon pricing from the supply-side perspective for carbon assets to solve a recent low price issue, which may delay the development of emission reduction technologies in the sense of marginal abatement costs. We propose a carbon pricing model linked to crude oil prices, which has historically been employed in supply-side driven pricing of long-term contracts for energy trading in the early stage. Since the model is designed to hold carbon prices between certain lower and upper boundaries using S-shaped carbon price linkage to crude oil prices, it can be useful to overcome a recent low carbon price issue. In addition, it is shown that the model can alleviate the difficulties of carbon derivative pricing in selecting market price of risk. Empirical studies using EUA and Brent crude oil futures prices estimate the parameters of the Brent crude oil-linked EUA price model. EUA prices simulated from the model with the parameter estimates are compared with historical EUA prices. The results suggest that simulated EUA prices from the model be kept relatively higher than historical EUA prices. This is preferable for accelerating carbon emission reductions in that emission reduction technologies with high marginal abatement costs are affordable. It may imply that EUA must be priced using a crude oil-linked carbon price model in the early stage of EUA trading until EUA markets are fully matured from the supply-side perspective for carbon asset pricing, not employing a premature market-based or supply and demand-based carbon price model. To show usefulness of crude oil-linked carbon pricing, we also give a numerical example of European carbon option pricing based on the Brent crude oil-linked EUA price model by using Crank-Nicolson finite difference method. Finally we discuss the relation between crude oil-linked carbon pricing and emission reduction risk. These studies may suggest carbon policy makers take into account of crude oil-linked carbon pricing to tackle low price and low liquidity issues of carbon assets