CO₂ investment risk analysis

Utilities with hard coal and lignite power plants, manufacturers, and aviation companies in the EU that emit greenhouse gases must invest in emission allowances to run their operations. The buy side of the capital market (e.g. hedge funds, insurers, and pension plans) can invest in these allowances to realise an investment asset which is uncorrelated to traditional market-risk investments. Given the high volatility of the price of emission allowances, all investors in emission allowances face a challenging risk-return situation that requires a thorough risk analysis. We show that this analysis can be undertaken using extreme value theory. For the analysed extreme emission allowance price returns, we identified saliently good fits between the empirical and theoretical Pareto distributions. We further show that emission allowances present an interesting investment case.