Flexibility premium of emissions permits

Luca Taschini

doi:10.1016/j.jedc.2020.104013

Abstract

Investments in abatement technology are often characterised by irreversibility and significant implementation lags, whereas emissions permits can be traded at any time. As such, abatement and emissions permit trading systems are hardly perfect substitutes. We formally study the flexibility of emissions permits and propose a unified framework to rationalise the impact of both investment/divestment lags and irreversibility in relation to the price of emissions permits. Using option pricing concepts, we reformulate the technology adoption problem in terms of the technology’s characteristics (irreversibility and implementation lags) and offer a conceptual quantification of the flexibility premium of emissions permits.

Highlights

A cap-and-trade programme sets a maximum level of pollution – a cap – and distributes emissions permits among businesses that produce emissions
0.452 0.455 0.458 we model the main groups of industries currently regulated under cap-and-trade programmes: (1) those few electricity generation industries characterised by virtually instantaneous and reversible abatement options and (2a) those energy-intensive industries characterised by long investment lags or (2b) irreversible investments in durable equipment
Trading is reversible and instantaneous, whereas abatement investments are often not reversible and the technology adoption is usually subject to implementation lags

Summary

Introduction

A cap-and-trade programme sets a maximum level of pollution – a cap – and distributes emissions permits among businesses that produce emissions. This paper proposes a general model to describe and rigorously analyse how firms respond to cap-and-trade regulations when abatement technologies are characterised by implementation lags and irreversibility It provides new insights for the role of permit markets in achieving net-zero emissions, by explicitly considering the characteristics of alternative abatement technologies, and contributes to the debate about which carbon price levels are consistent with climate neutrality (Stern and Stiglitz, 2017 and Burke et al, 2019). Chao and Wilson show that the price of emissions permits can exceed the marginal cost of abatement by an amount that captures permits’ reversibility/divestment optionality They show that investments in abatement are reduced when the uncertainty about product demand is significant.

The decomposition of the permit price

The flexibility premium

Quantitative illustration

Findings

Conclusion