Valuing Tradable Private Rights to Pollute the Public's Air

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Abstract
This study develops the economic rationale for the inclusion of new environmental financial assets, tradable pollution rights, in a well‐diversified portfolio. These new assets are generated and their valuation determined in the market‐incentive environmental regulatory approach called emissions trading, especially the cap‐and‐trade variant. This approach has been gaining wide acceptance and approval. A leading example is the sulfur dioxide market where tradable allowances are assets that may be held by private investors. Transactions in this market have reached volumes indicative of a high degree of liquidity. Comparable tradable rights in other pollutants are under active development. We explain the design and workings of these markets and demonstrate empirically, on the basis of time series data, that sulfur dioxide allowances have rates of return and yield distributions that make them candidates for inclusion in asset portfolios. We conjecture that other tradable pollution rights will exhibit similar properties when sufficient data are available. Financial analysts and accountants are likely to play an increasing role in advising investors about the role of these assets in a well‐diversified portfolio.

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