Does a cap on the carbon price have to be a cap on green investments?

Abstract

Policy makers and economists are discussing a regulatory ceiling for carbon prices, acting as a “safety valve” for the protection of regulated businesses from unexpected price surges. While the pros and cons of such a regulatory feature are widely discussed in the literature, the optimal design of such a cap and the attendant economic and environmental consequences have yet to be subjected to quantitative analyses. We employ a Monte Carlo simulation/dynamic programming approach to investigate the impact of different carbon price cap designs on an individual firm in the energy generation industry. Specifically, we model the firm’s choice between a pulverized coal combustion plant and a combined cycle gas turbine plant, a large hydropower plant, a solid biomass plant and an on-shore wind farm. Our results show that the effects of a maximum carbon price set by the regulator is largely independent of its exact characteristics, albeit not of its level. A higher cap favors low-carbon technologies in general. However, due to differences in their cost structures, a price cap has different impacts on the relative attractiveness of the specific alternative technologies investigated.