Decision and Performance Analysis of a Price-Setting Manufacturer with Options under a Flexible-Cap Emission Trading Scheme (ETS)

An Emission Trading Scheme (ETS) is widely considered to reduce carbon emissions and achieve sustainability. Unsatisfactory results of European Union Emission trading scheme (EU ETS) make China’s government propose a flexible-cap ETS system to overcome its weakness. This research is the first one introducing the flexible cap to limit the manufacturing carbon footprint. Current research on emission reduction primarily focuses on introducing option contracts to better develop the carbon market, with little consideration of the effectiveness of these contracts on the manufacturer’s optimality facing demand risks. This research fills this research gap by using call option contract to reduce the emission costs for a price-setting manufacturer under the flexible ETS. Newsvendor models are built to investigate the behaviours and performances of manufacturers, with a call option contract when the price-driven demand is uncertain. The joint emission ordering and product pricing problem is solved by three emission ordering policies: the non-option, only option, and mixed emission ordering policy. Analytical and numerical studies have shown that the mixed policy outperforms the others in profitability, and the only option policy provides more flexibility but poor profitability. Furthermore, the mixed ordering policy better protects against price volatility and stringent emission restrictions. Managerial insights help emission-dependent manufacturers to manage their carbon assets for better survival in an increasingly stringent emission market. This paper investigates the effectiveness of the option contract on manufacture optimality in the flexible-cap ETS system, in which the joint emission ordering and production pricing problem under demand uncertainty is solved by the newsvendor model.