FEEM working papers "Note di lavoro" series
2011 .074

Inducing Low-Carbon Investment in the Electric Power Industry through a Price Floor for Emissions Trading


Authors: Alexander Brauneis, Michael Loretz
Series: Climate Change and Sustainable Development
Editor: Carlo Carraro
Keywords: Carbon price, price floor, technological change, investment decision, real option approach
JEL n.: D81, O38, Q55

Abstract

Uncertainty about long-term climate policy is a major driving force in the evolution of the carbon market price. Since this price enters the investment decision process of regulated firms, this uncertainty increases the cost of capital for investors and might deter invest-ments into new technologies at the company level. We apply a real options-based approach to assess the impact of climate change policy in the form of a constant or growing price floor on investment decisions of a single firm in a competitive environment. This firm has the opportunity to switch from a high-carbon “dirty” technology to a low-carbon “clean” technology. Using Monte Carlo simulation and dynamic programming techniques for real market data, we determine the optimal CO2 price floor level and growth rate in order to induce investments into the low-carbon technology. We show these findings to be robust to a large variety of input parameter settings.

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