Design and pricing of an option product for China's green electricity-carbon medium and long-term markets

Abstract

Promoting market-based reform of Green Electricity Trading (GET) and Carbon Emission Trading (CET) is a critical pathway to achieve China's ‘carbon peaking and carbon neutrality’ goals. While existing studies have explored the synergistic relationship between electricity trading and CET markets, limited attention has been paid to the role of financial derivatives in fostering deeper collaboration in the ‘Green Electricity-Carbon’ (GE-C) medium and long-term market. This study designed a tailor-made option product for the China's GE-C medium and long-term market, which selected the weighted spot price of Green Electricity (GE) and carbon allowances as the underlying asset. A modified Black-Scholes real options pricing model was developed to price the option, with the impacts of six key factors on the option premium analysed by using a numerical case study. The results indicate that the GE-C option product effectively reflects the environmental value of GE through incorporating carbon abatement costs, and enhancing the GE's market competitiveness and investment attractiveness. When the ratio of GE price to carbon allowance price ranges from 1:0.1 to 1:0.5, option premium pricing shows lower volatility. Among the factors impacting option premiums, the strike price shows the greatest impact, with higher strike prices resulting in lower premiums, while the risk-free rate has the least impact. This study provides a practical framework for electricity generation and grid enterprises to participate in market transactions, promoting the growth of the GE industry and strengthening the synergy between China's GE and CET markets.