The impact of stochastic fuel prices premium on emission compliance strategy and emission credit price

Emission credit trading provides an added emission control alternative for firms under emission regulation. Pricing emission credits and solving for optimal compliance strategies are two of the most important problems in a firm's compliance consideration. Many studies have been done to examine the end-of-the-pipe control technologies, such as retrofitting. Alternatively, using cleaner-burning fuel as a beginning-of-the-pipe control strategy becomes viable due to technological innovation. This research conducts a thorough investigation on the firm's compliance problem under fuel switching and intertemporal credit trading with respect to terminal, continual and year-by-year compliance constraints; and provides an equilibrium framework to price emission credit term structure under the impact of stochastic fuel prices premium when cleaner-burning fuel is used.; Analytically, we conclude that the discounted expected future prices are downward sloping, and are governed by the associated adjoint multipliers of the optimal control problem. Geometric Brownian Motion (GBM) and Geometric Ornstein Uhlenbeck (GOU) as governing process for the fuel premium process are compared in numerical analysis. GOU assumption is shown to generate dynamic fuel switching strategies while GBM suggests deterministic strategies due to its inability to capture varying outlook of fuel premium. From the sensitivity analysis on GOU parameters, we further observe that the expectation of credit term structure is determined by the expected fuel premium outlook and the possibility for the outlook to change; while the volatility of credit term structure is determined by the volatility of fuel premiums.; The obtained credit term structure is then used in two applications. The first application demonstrates the hedging ability of credit trading to control a firm's compliance risk; the second application studies emission credit option pricing. Numerical comparison shows that Black-Scholes formula does not fit for credit option pricing due to the emission credit behaviors from firms' optimal fuel switching strategies. In addition, an extended formulation and relevant results are given for irreversible or partially reversible fuel switching process with transaction costs.