Commitments through financial options: an alternative for delivering climate change obligations

Governments willing to commit themselves to maintain carbon prices at or above a certain level face the challenge that their commitments need to be credible both for investors in low-carbon technology and for foreign governments. This article argues that governments can make such commitments by issuing long-term put option contracts on the price of CO2 allowances. This mechanism gives investors the right, but not the obligation, to sell allowances to the government at the strike price. From the investors' point of view, a government is therefore fully committed to a price floor for allowances in the future. This proposed approach alters the incentives that a government faces when considering noncompliance and serves to prevent non-compliance. The proposal fares well when assessed against criteria to determine its suitability in legitimacy, enforcement, proportionality, lack of interference from other contracting States, and transparency. It also allows for fine-tuning through the number and duration of issued options and the strike price. A robust contract structure is proposed to protect against government interference that might threaten the credibility of commitments.

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