Innovation and risk-averse firms: Options on carbon allowances as a hedging tool

Szolgayova J, Golub A, & Fuss S (2014). Innovation and risk-averse firms: Options on carbon allowances as a hedging tool. Energy Policy 70: 227-235. DOI:10.1016/j.enpol.2014.03.012.

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Abstract

In a regulated world where government seeks to decarbonize the energy sector, firms face both indirect and direct costs of emitting CO2. This study seeks to take the perspective of the firm, which needs to maximize profits implying minimization of (carbon) cost as well. In this study, the firm can compose the cost-optimal portfolio of (a) investing into carbon-saving technology, which is currently expensive, (b) investing into carbon-saving technology R&D and adopt this technology at a later point, (c) buying allowances per ton of emitted CO2 in a carbon market (alternatively this could be formulated as a tax), and (d) buying offsets traded in the same market, which are based on reduced emissions from deforestation and degradation (REDD+). Uncertainties in the cost of carbon coming from a lack of commitment in policy-making leading to fluctuations in markets and uncertainty in the payoff of R&D activities could provide disincentives to incur large up-front sunk cost and raise the economic value of being flexible. We apply a real options approach with stochastic carbon-saving technology costs and stochastic CO2 costs. Assuming that firms are risk-averse, they will not only value flexibility, but also risk reductions from diversification over the different (carbon mitigation) options.

Item Type: Article
Uncontrolled Keywords: Carbon trading scheme; Stochastic technological change; Option pricing
Research Programs: Ecosystems Services and Management (ESM)
Bibliographic Reference: Energy Policy; 70:227-235 (July 2014) (Published online 18 April 2014)
Depositing User: IIASA Import
Date Deposited: 15 Jan 2016 08:50
Last Modified: 24 Aug 2016 11:34
URI: http://pure.iiasa.ac.at/10916

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