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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.

A new financial asset (Allotment Trading Unit or ATU) that allows a firm to pollute was issued to a number of Chicago firms in 2000 as part of a cap‐and‐trade model to reduce emissions in the Chicago area. A model of this market was developed to enable us to: 1.) Estimate equilibrium tradable credit prices and quantities and calculate compliance costs for comparison with traditional environmental regulation; 2.) Estimate the consequences for prices and quantities of introducing changing emitter costs; and 3.) Estimate the impacts on prices and quantities of changing market features such as auctioning tradable credits instead of a free allocation, introducing spatial constraints, and changing the emissions cap. The model's results on the price determination of this new financial asset are of interest to accountants and financial analysts. A dated bankable ATU credit has a one‐year life expectancy, but future tradable credits can be bought or sold for use at the appropriate future date. It is an intangible asset that should be disclosed, measured and valued. The valuation to place on this asset is an important research topic in finance and accounting and various valuation approaches are discussed to handle the short‐term and long‐term price paths.

In recent years, there has been a steady rise in the use of marketable permits in environmental regulation. They have been employed as tools to control both air and water pollution, and have been implemented on local, regional, and national scales. These trading regimes - based upon a single market in emission permits - do not control the distribution of emissions throughout the trading region or prevent the formation of “hot spots” of pollution. In this chapter, we propose a marketable permit scheme that is consistent with the attainment of ambient standards and that does not significantly interfere with the benefits of trading.