An alternative mechanism for carbon emission permit price volatility mitigation

In this paper, we propose a stylized model to investigate the impact of financial options on mitigating carbon permit price volatility under a cap and trade system. We show that both the spot price level and the price volatility of carbon permits can be reduced via financial options, while ensuring market efficiency and achieving the emission target. The existence of an option market also provides a way to hedge the uncertainty of future spot prices and is a stimulus for investment in carbon emission abatement technologies. A comparison of the policy implications of this mechanism, a safety valve and banking/borrowing is also described.