Date Added: Nov 2010
The authors present a novel approach to the pricing of financial instruments in emission markets, for example, the EU ETS. The proposed hybrid model is positioned between existing complex full equilibrium models and pure risk-neutral models. Using an exogenously specified demand for a polluting good it gives a causal explanation for the accumulation of CO2 emissions and takes into account the feedback effect from the cost of carbon to the rate at which the market emits CO2. They derive a forward-backward stochastic differential equation for the price process of the allowance certificate and solve the associated semilinear partial differential equation numerically.