  We present a novel approach to the pricing of financial instruments in
emission markets, for example, the EU ETS. The proposed structural model is
positioned between existing complex full equilibrium models and pure reduced
form models. Using an exogenously specified demand for a polluting good it
gives a causal explanation for the accumulation of CO2 emissions and takes into
account the feedback effect from the cost of carbon to the rate at which the
market emits CO2. We derive a forward-backward stochastic differential equation
for the price process of the allowance certificate and solve the associated
semilinear partial differential equation numerically. We also show that
derivatives written on the allowance certificate satisfy a linear partial
differential equation. The model is extended to emission markets with multiple
compliance periods and we analyse the impact different intertemporal connecting
mechanisms, such as borrowing, banking and withdrawal, have on the allowance
price.
