Market-based pollution abatement strategies: Risk management using emission option contracts

In this work, a model for incorporating market-based pollution abatement instruments in the technology selection decision of a firm is developed. Multistage stochastic programming is used to model emission and market uncertainties while accounting for the availability of derivative instruments such as emission option contracts. The model quantifies the benefits of the flexibility offered by these instruments in minimizing total pollution abatement costs and helps in predicting the environmental liability faced by a firm in terms of the probability of meeting both compliance requirements in the future and the resulting noncompliance penalties. Management of environmental and financial risks is also addressed by linking the optimization model with basic statistical and probabilistic techniques.