Energy Price Jumps, Fat Tails and Climate Policy

Abstract

Addressing global climate change is likely to require broad-based deployment of new infrastructure. This new infrastructure is likely to be both costly to build and difficult to reverse – suggesting the deployment of new infrastructure is an example of “investment under uncertainty” (Dixit and Pindyck; 1993). In this context, a key concept is the “option value of waiting,” i.e., the potential gain in value that arises from waiting to learn more about the evolution of some key underlying stochastic ingredient, such as a commodity price or the cost of a carbon permit. We argue that this option value of waiting is likely to be increased by the presence of jumps (i.e., unexpectedly rapid changes in the key price), or fat tails (i.e., abnormally large kurtosis). Fat tails can arise from either jumps or time-varying volatility. Assuming there is some urgency in undertaking these investments, the increase in option value of waiting is worrisome, and motivates the deployment of a policy intervention that reduces this option value.