Abstract
This paper demonstrates how to use the real option approach to make a physical capital investment decision under the presence of the government credibility problem. Specifically, I study a rational firm’s optimal decision to build an electric power plant when the firm believes that there is a CO2 policy risk. Least-square Monte-Carlo simulations make the following predictions. First, with the current high energy commodities volatilities and physical capital costs, a rational firm invests in power plants early and the government credibility problem does not substantially increase such short investment timing. Second, the time-inconsistency problem does increase the investment into less-green plants and the expected profit of a rational firm. The methodology in this paper is general and applicable to other areas in finance.
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