Abstract
This article studies the effect of different subsidy characteristics, like its size and withdrawal probability, on optimal investment timing and size. We find that increasing the risk of subsidy withdrawal, as well as increasing subsidy size, increases the firm's incentive to invest earlier but decreases the optimal investment size. We show that the optimal investment size is larger when no subsidy is implemented, although the firm will invest later then. A subsidy increases total welfare when subsidy withdrawal risk is very low or absent. If a policy maker aims at maximizing welfare, we show that the larger the subsidy withdrawal risk, the smaller the optimal subsidy is. When the policy maker aims to increase capacity, a subsidy is ineffective. However, a lump-sum tax can increase the firm's optimal capacity, at the cost of a delay in investment.
Highlights
In an attempt to limit climate change, many countries have set ambitious targets to reduce greenhouse gas emissions during the past two decades
This paper studies the effect of a lump-sum subsidy subject to risk of retraction on optimal investment decisions in terms of timing and capacity size installed
We find that increasing the likelihood of subsidy withdrawal gives the firm an incentive to invest sooner to still obtain the subsidy
Summary
In an attempt to limit climate change, many countries have set ambitious targets to reduce greenhouse gas emissions during the past two decades. This paper aims to determine how the optimal investment decisions related to renewable energy projects depend on the availability of a subsidy, the size of the subsidy and the withdrawal risk of the subsidy. The effect of uncertainty in availability of a subsidy on investment behavior strongly depends on the type of subsidy in place as well as the level of uncertainty We contribute to this literature by studying a lumpsum investment subsidy, the most widespread policy instrument for renewable energy globally [REN21, 2018a, page 70], and study the role of subsidy size and the risk of potential subsidy withdrawal on investment. The section investigates whether introducing a subsidy can achieve this
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