---
title: "Emissions and Environmental Markets"
book: "Markets III: Commodities, Energy and Crypto"
subject: quant
language: en
chapter: 7
exercises: 8
source: https://one-course.com/books/quant/3/en/chapter/7-emissions-and-environmental-markets
---

# Chapter 7 — Emissions and Environmental Markets

By 30 September each year, a steel plant in Europe must hand over to the authorities one allowance for every tonne of carbon dioxide it emitted the year before. On 21 February 2023 an allowance changed hands above 100 euros for the first time. For an industry that emits tonnes of carbon dioxide for every tonne of product, allowances had become a cost to hedge like its coal and ore. [Emission allowances](#def-m3-emissions-and-environmental-markets-cap) are a market created by law: the regulator fixes the quantity, the market finds the price. This chapter describes how [cap-and-trade](#def-m3-emissions-and-environmental-markets-cap) works, how the European system manages its supply, how carbon enters power prices through the [merit order](https://one-course.com/books/quant/3/en/chapter/5-power-markets-i-design#def-m3-power-markets-design-merit), and the certificates that trade alongside.

## 7.1 Cap and trade

**Definition 7.1 (Cap-and-trade, emission allowance).**

*Cap-and-trade* is a regulation that caps the total emissions of covered installations over a period, issues that many *emission allowances* (each a right to emit one tonne of CO$_2$ or its equivalent), and requires every installation to hold and give up allowances for its emissions, leaving the allowances free to be traded.

The trade is the point: an installation that can cut a tonne for less than the allowance price cuts it and sells the allowance; one that cannot buys. The cap is met by the cheapest reductions available, whoever owns them, and the price tells everyone what a tonne is worth. A tax fixes the price and lets the quantity follow; a cap fixes the quantity and lets the price follow.

**Definition 7.2 (Allowance surrender, free allocation).**

*Allowance surrender* is the annual handing-over by an operator to its registry of allowances equal to its verified emissions of the previous year; the surrendered allowances are cancelled. *Free allocation* is the distribution of part of the cap to installations without charge, by benchmark rules; the rest is auctioned.

![The compliance cycle of the European system for one year of emissions, with the deadlines in force since 2024. Schematic.](https://one-course.com/images/onecourse/chapters/quant-3/m3-emissions-and-environmental-markets/fig-834e4ea64e45.svg)

***Figure 7.1.** The compliance cycle of the European system for one year of emissions, with the deadlines in force since 2024. Schematic.*

## 7.2 The European system

The European Union’s emissions trading system started in 2005 and covers power generation, heavy industry, aviation within Europe and, since 2024, shipping. Its cap falls every year; power generators buy all their allowances, while industries exposed to foreign competition receive part of theirs free. Allowances not allocated free are sold at regular auctions, and they trade as spot and as futures.

**As of September 2026 — European compliance and scope.**

Since 2024 operators surrender allowances for the previous year’s emissions by 30 September (before, 30 April), after submitting a verified emissions report by 31 March. An operator short on the day pays an excess emissions penalty of EUR 100 a tonne, indexed to consumer prices for allowances issued from 2013, and must still surrender the missing allowances the following year. A second system for fuels used in buildings and road transport (ETS2) was due to start in 2027; in March 2026 the Parliament and the Council agreed to postpone it to 2028.

## 7.3 The market stability reserve

A cap fixes the quantity, but when demand falls (a recession, a pandemic, cheap renewables) a fixed quantity leaves a surplus that depresses the price for years. The European system answers with a rule that adjusts future auction volumes.

**Definition 7.3 (Market stability reserve, total number of allowances in circulation).**

The *total number of allowances in circulation* (TNAC) is the surplus of allowances held in the market: all allowances issued and not cancelled, minus those surrendered for emissions and those held in the reserve, published each year by the Commission. The *market stability reserve* (MSR) is a reserve into which allowances are withheld from future auctions when the TNAC is high, and from which they are released when it is low.

**Proposition 7.4 (The intake rule).**

Under the rules in force since 2024, the reserve takes over the twelve months from September: 24% of the TNAC if the TNAC exceeds 1 096 million; the TNAC minus 833 million if it lies between 833 and 1 096 million; nothing between 400 and 833 million; and it releases 100 million if the TNAC falls below 400 million. Allowances held in the reserve above 400 million cease to be valid.

**Proof.** This is the rule as amended in 2023; the continuous piece between 833 and 1 096 million removes the jump that a flat 24% would cause at 833 million ([Figure 7.2](#fig-m3-emissions-and-environmental-markets-msr)). ∎

**Example 7.5 (Two published years).**

The TNAC published in 2025 was 1 148 049 585 allowances, above 1 096 million: the reserve takes 24%, 275 531 900 allowances, from September 2025 to August 2026. The TNAC published on 29 May 2026 was 1 023 494 202: the reserve takes the excess over 833 million, 190 494 202 allowances, from September 2026 to August 2027.

![Allowances withheld from auctions over twelve months as a function of the published surplus (negative: released), with the two most recent publications. Data: the Decision as amended in 2023; Commission publications of 2025 and 2026.](https://one-course.com/images/onecourse/chapters/quant-3/m3-emissions-and-environmental-markets/fig-05a7a8546786.svg)

***Figure 7.2.** Allowances withheld from auctions over twelve months as a function of the published surplus (negative: released), with the two most recent publications. Data: the Decision as amended in 2023; Commission publications of 2025 and 2026.*

The reserve turns a fixed cap into a supply curve: the more the market holds, the fewer allowances are auctioned. A trader who forecasts the TNAC forecasts next year’s auction supply.

## 7.4 Carbon in the merit order

A plant’s marginal cost includes its allowances: $(P_{\mathrm{fuel}} + e\,P_{\mathrm{CO_2}})/\eta$ ([Chapter 5](https://one-course.com/books/quant/3/en/chapter/5-power-markets-i-design#ch-m3-power-markets-design)). Coal emits more per MWh of fuel than gas and burns it less efficiently, so a higher carbon price moves coal plants up the [merit order](https://one-course.com/books/quant/3/en/chapter/5-power-markets-i-design#def-m3-power-markets-design-merit).

**Definition 7.6 (Clean spark spread, clean dark spread).**

The *clean spark spread* is the [spark spread](https://one-course.com/books/quant/3/en/chapter/5-power-markets-i-design#def-m3-power-markets-design-spark) minus the cost of the allowances for one MWh of electricity from a gas plant, $P_{\mathrm{power}} - (P_{\mathrm{gas}} +
e_g P_{\mathrm{CO_2}})/\eta_g$; the *clean dark spread* is the same for a coal plant.

**Definition 7.7 (Switching price).**

The coal-to-gas *switching price* is the allowance price at which a given gas plant and a given coal plant have the same marginal cost:

$$
P^{\star}_{\mathrm{CO_2}} = \frac{P_{\mathrm{gas}}/\eta_g - P_{\mathrm{coal}}/\eta_c}{e_c/\eta_c - e_g/\eta_g}.
$$

**Example 7.8 (Where gas beats coal).**

With gas at $35\,\mathrm{EUR}/\mathrm{MWh}$ of fuel, coal at $12\,$, efficiencies of 55% and 40%, and emission factors of 0.202 and 0.341 tonnes per MWh of fuel (illustrative round numbers), a MWh of electricity emits 0.367 t from gas and 0.853 t from coal, and the [switching price](#def-m3-emissions-and-environmental-markets-switch) is $69.32\,\mathrm{EUR}/\mathrm{t}$. At $70\,\mathrm{EUR}/\mathrm{t}$ and power at $100\,\mathrm{EUR}/\mathrm{MWh}$ the [clean spark spread](#def-m3-emissions-and-environmental-markets-clean) is $10.65\,$ and the [clean dark spread](#def-m3-emissions-and-environmental-markets-clean) $10.32\,\mathrm{EUR}/\mathrm{MWh}$: gas is just ahead.

![Clean spreads of the plants of against the allowance price, with power at 100\, EUR/ MWh. Coal’s spread falls 2.3 times as fast; the lines cross at the switching price. Data: the chapter’s tutorial.](https://one-course.com/images/onecourse/chapters/quant-3/m3-emissions-and-environmental-markets/fig-19e034c0ae83.svg)

***Figure 7.3.** Clean spreads of the plants of [Example 7.8](#ex-m3-emissions-and-environmental-markets-switch) against the allowance price, with power at $100\,\mathrm{EUR}/\mathrm{MWh}$. Coal’s spread falls 2.3 times as fast; the lines cross at the [switching price](#def-m3-emissions-and-environmental-markets-switch). Data: the chapter’s tutorial.*

The [switching price](#def-m3-emissions-and-environmental-markets-switch) moves with gas. With gas at $20\,\mathrm{EUR}/\mathrm{MWh}$ of fuel it is $13.11\,\mathrm{EUR}/\mathrm{t}$; with gas at $50\,\mathrm{EUR}/\mathrm{MWh}$ it is $125.53\,\mathrm{EUR}/\mathrm{t}$ ([Figure 7.4](#fig-m3-emissions-and-environmental-markets-switch)). With European gas between $27 and $70 per MMBtu in every month of 2022 ([Chapter 4](https://one-course.com/books/quant/3/en/chapter/4-natural-gas-and-lng#ch-m3-natural-gas-and-lng)), the [switching price](#def-m3-emissions-and-environmental-markets-switch) was far above any allowance price seen, and coal ran ahead of gas.

![The allowance price that makes the gas and coal plants of equal, as the gas price varies with coal at 12\, EUR/ MWh. Data: the chapter’s tutorial.](https://one-course.com/images/onecourse/chapters/quant-3/m3-emissions-and-environmental-markets/fig-b5454a0ef2a0.svg)

***Figure 7.4.** The allowance price that makes the gas and coal plants of [Example 7.8](#ex-m3-emissions-and-environmental-markets-switch) equal, as the gas price varies with coal at $12\,\mathrm{EUR}/\mathrm{MWh}$. Data: the chapter’s tutorial.*

## 7.5 Other systems and the border adjustment

**As of September 2026 — Emissions trading worldwide.**

The International Carbon Action Partnership counted 41 emissions trading systems in force in February 2026, covering 26% of global greenhouse-gas emissions in jurisdictions that produce 63% of world GDP, with national systems launching in 2026 in Japan, India and Vietnam.

A system that prices carbon at home but not on imports invites production to move abroad. The European answer is a charge at the border.

**Definition 7.9 (Carbon border adjustment mechanism).**

The *carbon border adjustment mechanism* (CBAM) requires importers of certain carbon-intensive goods into the European Union (iron and steel, aluminium, cement, fertilisers, electricity, hydrogen) to buy certificates for the emissions embedded in them, priced on the allowance price, less any carbon price paid where they were made.

**As of September 2026 — CBAM timetable.**

The definitive period began on 1 January 2026. Regulation (EU) 2025/2083 exempts importers of less than 50 tonnes a year of covered goods (other than hydrogen and electricity) and postponed the start of certificate sales from 1 January 2026 to 1 February 2027.

## 7.6 Certificates of origin and carbon credits

Allowances are one of several environmental instruments. Others certify attributes rather than rights to emit.

**Definition 7.10 (Guarantee of origin, renewable energy certificate).**

A *guarantee of origin* is an electronic document, issued in the European Union for each MWh of renewable energy on request of its producer, whose sole function is to prove to a final customer that a given quantity of energy was produced from renewable sources. A *renewable energy certificate* is the US equivalent: a tradable instrument representing the renewable attributes of one MWh of renewable electricity.

**Definition 7.11 (Carbon credit).**

A *carbon credit* (or offset) is a certificate representing one tonne of CO$_2$ equivalent reduced or removed by a project outside a cap, issued by a crediting standard, and used voluntarily by buyers to claim compensation for their own emissions.

The three instruments differ in what backs them. An allowance is a legal right within a cap, its supply fixed by law. A [guarantee of origin](#def-m3-emissions-and-environmental-markets-go) certifies how a MWh was produced; its price reflects the demand of consumers who want green claims. A [carbon credit](#def-m3-emissions-and-environmental-markets-credit) is a claim about a counterfactual (what would have been emitted without the project), and its value rests on the credibility of that claim.

## 7.7 Tutorial: the reserve and the switching price

**Goal.** Apply the reserve’s rule to the published surplus, and compute the [switching price](#def-m3-emissions-and-environmental-markets-switch) and clean spreads. **End state:** Examples [7.5](#ex-m3-emissions-and-environmental-markets-msr) and [7.8](#ex-m3-emissions-and-environmental-markets-switch) and Figures [7.2](#fig-m3-emissions-and-environmental-markets-msr) and [7.3](#fig-m3-emissions-and-environmental-markets-spreads).

1. **The rule.** [Proposition 7.4](#prop-m3-emissions-and-environmental-markets-msr). `def msr_intake (tnac: int ) -> int : """Allowances placed in (positive) or released from (negative) the market stability reserve over the next twelve months from September, given the published TNAC (rules in force from 2024): 24% of the TNAC above 1,096 million; the excess over 833 million between 833 and 1,096 million; a release of 100 million below 400 million; nothing otherwise.""" if tnac > 1_096 * MILLION: return round (0.24 * tnac) if tnac > 833 * MILLION: return tnac - 833 * MILLION if tnac < 400 * MILLION: return -100 * MILLION return 0` **Listing 7.1.** The reserve’s intake rule. code/firm/carbon/firm_carbon.py
2. **Spreads and switching.** `def emissions_per_mwh (efficiency: float , factor: float ) -> float : """Tonnes of CO2 per MWh of electricity.""" return factor / efficiency def clean_spread (power: float , fuel: float , carbon: float , efficiency: float , factor: float ) -> float : """Power price minus fuel and carbon cost of one MWh of electricity: the clean spark spread for gas, the clean dark spread for coal.""" return power - (fuel + factor * carbon) / efficiency def switching_price (gas: float , coal: float , eff_gas: float , eff_coal: float , ef_gas: float = 0.202 , ef_coal: float = 0.341 ) -> float : """Allowance price at which a gas plant and a coal plant have the same marginal cost.""" return (gas / eff_gas - coal / eff_coal) / (ef_coal / eff_coal - ef_gas / eff_gas)` **Listing 7.2.** Emissions per MWh, clean spreads and the switching price. code/firm/carbon/firm_carbon.py
3. **Run** `m3_carbon.msr_cases()` , `utility()` and `fig_carbon.py` .

**What to change next.** Lower coal’s efficiency to 36% and find the new [switching price](#def-m3-emissions-and-environmental-markets-switch); model a year in which the TNAC falls below 833 million and the reserve stops taking allowances.

## 7.8 Build: the compliance book

**Purpose.** The miniature firm’s generating assets need allowances; its traders price clean spreads and forecast auction supply. The compliance book keeps allowances against emissions and computes what the reserve will do next September.

**Interface.** `msr_intake(tnac)`; `emissions_per_mwh(efficiency, factor)`; `clean_spread(power, fuel, carbon, efficiency, factor)`; `switching_price(gas, coal, eff_gas, eff_coal)`; `ComplianceAccount.buy / emit / surrender`.

**Rules.** Tonnes are integers; surrender covers the oldest uncovered emissions and returns the shortfall; the reserve rule reproduces the Commission’s published intakes to the allowance.

**Acceptance tests.** `code/firm/carbon/tests/`: the 2025 and 2026 intakes exactly; equal clean spreads at the [switching price](#def-m3-emissions-and-environmental-markets-switch); a shortfall and its cure.

**Stretch.** Read the day-ahead prices of `firm.dayahead` and compute each plant’s clean spread per hour; a forward curve of allowances with the cost of carry.

Sources and further reading

- European Commission, Market Stability Reserve page and the Communications on the TNAC of 2025 and 2026; Decision (EU) 2015/1814 as amended by Decision (EU) 2023/852.
- Directive (EU) 2023/959 (surrender deadline); Directive 2003/87/EC, consolidated text of 1 March 2024, Article 16(3)–(4) (Internet Archive copy of EUR-Lex); Council and Parliament agreement on ETS2 (2026).
- Regulation (EU) 2023/956 (CBAM) and Regulation (EU) 2025/2083.
- Directive (EU) 2018/2001, Article 19 (guarantees of origin).
- ICAP, *Emissions Trading Worldwide: Status Report 2026* .
- Reuters report of 21 February 2023 on the EUA price (via MarketScreener).

## 7.9 Exercises

**Exercise 7.1 ★.**

A plant emitted 1 000 tonnes, holds 900 allowances and buys 100 more before the deadline. What does it surrender, and when?

**Solution of Exercise 7.1.**

It surrenders 1 000 allowances, by 30 September of the year after the emissions; the 100 bought cover the shortfall.

**Exercise 7.2 ★.**

What does the reserve do if the published TNAC is 1 200 million? 900 million? 350 million?

**Solution of Exercise 7.2.**

At 1 200 million it withholds 24%, 288 million; at 900 million, the excess over 833 million, 67 million; at 350 million it releases 100 million.

**Exercise 7.3 ★.**

How does a cap differ from a tax when demand for emitting falls sharply?

**Solution of Exercise 7.3.**

Under a tax the price stays and emissions fall with demand; under a cap the quantity stays at the cap and the price falls, leaving a surplus that can depress prices for years unless a mechanism such as the reserve reduces future supply.

**Exercise 7.4 ★★.**

With the plants of [Example 7.8](#ex-m3-emissions-and-environmental-markets-switch), what is the [switching price](#def-m3-emissions-and-environmental-markets-switch) if gas costs $20\,\mathrm{EUR}/\mathrm{MWh}$? And if coal’s efficiency is 38%, with gas at $35\,$?

**Solution of Exercise 7.4.**

$13.11\,\mathrm{EUR}/\mathrm{t}$ with gas at $20\,$; $60.47\,\mathrm{EUR}/\mathrm{t}$ with coal at 38% and gas at $35\,$: the less efficient coal plant emits more per MWh, so a lower carbon price suffices.

**Exercise 7.5 ★★.**

How many tonnes does a 55%-efficient gas plant emit per MWh of electricity, and what does a 10-euro rise in the allowance price add to its marginal cost?

**Solution of Exercise 7.5.**

$0.202/0.55 = 0.367$ t per MWh; a 10-euro rise adds $3.67\,\mathrm{EUR}/\mathrm{MWh}$.

**Exercise 7.6 ★★.**

Why does a [guarantee of origin](#def-m3-emissions-and-environmental-markets-go) not reduce anyone’s emissions directly, while a surrendered allowance does?

**Solution of Exercise 7.6.**

A [guarantee of origin](#def-m3-emissions-and-environmental-markets-go) transfers a claim about how a MWh was produced; the renewable MWh was produced anyway and no cap binds the buyer. A surrendered allowance is cancelled within a cap: the total that can be emitted is fixed, so each tonne covered is one less available to anyone else.

**Exercise 7.7 ★★★.**

*Coding.* With `msr_intake`, find the TNAC between 800 and 1 200 million at which the intake is largest relative to the TNAC, and show that the rule is continuous at 1 096 million within a million.

**Solution of Exercise 7.7.**

Between 833 and 1 096 million the ratio $(T - 833)/T$ rises with $T$, to 23.996% at 1 096 million; above it the intake is 24% of $T$. At 1 096 million the two pieces give 263.00 and 263.04 million: continuous within 0.04 million.

**Exercise 7.8 ★★★.**

*Find the flaw.* “Allowances are cheap this year, so the cap is not binding and has no effect on emissions.”

**Solution of Exercise 7.8.**

A low price can mean the cap is being met cheaply (cheap abatement, low demand), not that it does not bind: emissions cannot exceed the cap whatever the price. The price measures the marginal cost of staying under the cap, and the surplus it leaves is banked for later years, when the cap is tighter.

## 7.10 Problem: The Utility’s Carbon Hedge

**Problem 7.1.**

Weekend problem — coal, gas and next year’s allowances

A utility plans to generate 6 TWh from coal (40% efficiency) and 4 TWh from gas (55%) next year, with the fuels and emission factors of [Example 7.8](#ex-m3-emissions-and-environmental-markets-switch). It receives no [free allocation](#def-m3-emissions-and-environmental-markets-surrender). Allowances trade at $70\,\mathrm{EUR}/\mathrm{t}$.

**Part I — Needs.**

1. How many tonnes does each MWh from coal and from gas emit?
2. How many allowances does the plan need?
3. What do they cost at $70\,\mathrm{EUR}/\mathrm{t}$ ?
4. When must they be surrendered?
5. Why does the utility buy them forward rather than when it emits?

**Part II — Switching.**

6. Give the [switching price](#def-m3-emissions-and-environmental-markets-switch) .
7. At $70\,\mathrm{EUR}/\mathrm{t}$ , which plant is cheaper, and by how much per MWh?
8. How many tonnes would moving 1 TWh from coal to gas save?
9. At what allowance price does that move pay?
10. What happens to the [switching price](#def-m3-emissions-and-environmental-markets-switch) if gas rises to $50\,\mathrm{EUR}/\mathrm{MWh}$ ?

**Part III — The market.**

11. What does the reserve’s rule imply for next year’s auction supply, given the TNAC of 2026?
12. How would a fall in industrial output affect the allowance price and the TNAC?
13. Why do power prices rise with allowance prices in a coal-marginal hour?
14. Who holds allowances besides compliance buyers, and why?
15. What does the border adjustment change for the utility?

**Part IV — Judgement.**

16. Why might the utility hedge its power sales and its allowances together?
17. What does a [clean dark spread](#def-m3-emissions-and-environmental-markets-clean) near zero say about the coal plant’s future?
18. Is the [switching price](#def-m3-emissions-and-environmental-markets-switch) a floor or a ceiling for allowances in a gas-rich year?
19. State the *named result* : the [switching price](#def-m3-emissions-and-environmental-markets-switch) and the allowances the plan needs.
20. In one sentence: what sets the price of an allowance?

**Solution of Problem 7.1.**

**1.** Coal $0.341/0.40 = 0.8525$ t per MWh; gas $0.202/0.55 = 0.3673$ t. **2.** $6 \times
0.8525 + 4 \times 0.3673 = 6.584$ million tonnes. **3.** About EUR 460.9 million. **4.** By 30 September of the year after. **5.** To fix the cost when it sells its power forward, and because waiting leaves it exposed to the price for up to 21 months. **6.** $69.32\,\mathrm{EUR}/\mathrm{t}$. **7.** Gas, by $0.33\,\mathrm{EUR}/\mathrm{MWh}$ (89.35 against 89.68). **8.** $(0.8525 - 0.3673) \times 10^6 = 485\,227$ tonnes. **9.** Above the [switching price](#def-m3-emissions-and-environmental-markets-switch), $69.32\,\mathrm{EUR}/\mathrm{t}$, ignoring each plant’s other costs. **10.** It rises to $125.53\,\mathrm{EUR}/\mathrm{t}$: coal becomes the cheaper plant at $70\,$. **11.** With the TNAC at 1 023 494 202, the reserve withholds 190 494 202 allowances from auctions from September 2026 to August 2027: supply falls. **12.** Lower demand lowers the price and raises the TNAC, which raises future intakes and tightens supply later. **13.** The marginal plant’s cost includes $0.8525 \times P_{\mathrm{CO_2}}$ per MWh, which the auction passes into the price. **14.** Financial investors and funds, speculators, and intermediaries who sell forward to compliance buyers; banks that hedge utilities. **15.** Nothing directly for its domestic power sales, but imported electricity and energy-intensive goods now carry a carbon cost, which changes competition. **16.** Its margin is a clean spread: the power price, fuel and carbon move together in the [merit order](https://one-course.com/books/quant/3/en/chapter/5-power-markets-i-design#def-m3-power-markets-design-merit), and hedging one leg alone leaves the spread open. **17.** That the plant earns little above fuel and carbon and will run less as the cap tightens: closure or conversion. **18.** When gas is cheap, coal-to-gas switching is the cheapest large abatement, so the [switching price](#def-m3-emissions-and-environmental-markets-switch) acts as a ceiling that the allowance price rarely exceeds while switching capacity remains. **19.** *Named result:* a [switching price](#def-m3-emissions-and-environmental-markets-switch) of $69.32\,\mathrm{EUR}/\mathrm{t}$, and 6.584 million allowances (about EUR 460.9 million at $70\,\mathrm{EUR}/\mathrm{t}$) for the plan. **20.** The cost of the marginal tonne of abatement needed to stay under the cap, now and in expectation (allowances can be banked).

## 7.11 Interview questions

**Interview question 7.1 ★ trader.**

What is the difference between a carbon tax and [cap-and-trade](#def-m3-emissions-and-environmental-markets-cap)?

**Solution of Interview question 7.1.**

A tax fixes the price per tonne and lets emissions adjust; [cap-and-trade](#def-m3-emissions-and-environmental-markets-cap) fixes the quantity and lets the price adjust through trade. Under uncertainty about abatement costs one fixes the outcome, the other the cost.

*What the interviewer is looking for: price versus quantity instrument, and who bears uncertainty.*

**Interview question 7.2 ★ trader, researcher.**

Define the [clean spark spread](#def-m3-emissions-and-environmental-markets-clean). When is it negative?

**Solution of Interview question 7.2.**

The power price minus the gas and carbon costs of one MWh from a gas plant. Negative when power is cheaper than the plant’s fuel plus allowances: in hours set by renewables or cheaper plants.

*What the interviewer is looking for: the formula with efficiency and emission factor.*

**Interview question 7.3 ★★ researcher.**

How does the [market stability reserve](#def-m3-emissions-and-environmental-markets-msr) change the elasticity of allowance supply?

**Solution of Interview question 7.3.**

It makes future auction supply decrease with the surplus: a high TNAC withdraws allowances, a low one releases them. Supply becomes a function of the market’s own holdings, which dampens persistent surpluses and supports prices after demand shocks.

*What the interviewer is looking for: endogenous supply.*

**Interview question 7.4 ★★ trader.**

Gas prices double. What happens to allowance prices, and why?

**Solution of Interview question 7.4.**

Dearer gas raises the [switching price](#def-m3-emissions-and-environmental-markets-switch), so more coal runs and power emits more per MWh: demand for allowances rises, and prices tend to rise; against that, high energy prices cut industrial output and demand. The net depends on which dominates.

*What the interviewer is looking for: fuel switching as a demand channel, and the offsetting activity effect.*

**Interview question 7.5 ★★ risk.**

A company buys [carbon credits](#def-m3-emissions-and-environmental-markets-credit) to claim neutrality. What risks does it carry?

**Solution of Interview question 7.5.**

Quality risk (credits whose reduction did not happen or would have happened anyway), permanence risk (forests that burn), reputational and legal risk (claims found misleading), and price risk if it must replace invalidated credits.

*What the interviewer is looking for: additionality, permanence, claims.*

**Interview question 7.6 ★★★ researcher, developer.**

Build a model of next year’s allowance demand from the power sector. What data and what structure?

**Solution of Interview question 7.6.**

A dispatch model: hourly demand, renewable output scenarios, the fleet with efficiencies and emission factors, fuel and carbon price scenarios, and interconnection; run the [merit order](https://one-course.com/books/quant/3/en/chapter/5-power-markets-i-design#def-m3-power-markets-design-merit) per hour and sum emissions. Data: fleet registries, historical dispatch, weather. Calibrate on past verified emissions.

*What the interviewer is looking for: a merit-order dispatch model and scenarios, calibrated to verified emissions.*