Investment dynamics in the energy sector under carbon price uncertainty and risk aversion

Abstract

Decarbonizing the electricity system in order to contribute to climate change mitigation is a key policy goal. Yet, uncertain political and economic conditions (e.g., electricity prices) create uncertainty for energy companies. The dynamics of carbon price developments and aversion to uncertainty may have decisive impacts on companies’ investment decisions and thus environmental and distributional outcomes. In this paper, we incorporate a dynamic portfolio approach in a simulation model of investments in the electricity sector to explore and disentangle the impacts of both uncertainty and risk aversion on companies’ investment decisions. We find that policy uncertainty and risk aversion tend to delay the transition to a low-carbon energy system, with higher levels of either factor causing even further delays. However, the mechanism for the delay depends on how risk aversion is modeled, e.g. whether companies are averse to losses, or variances or if they use a higher discount rate in uncertain situations. Employing the loss-averse approach, the company prefers technology with a low likelihood of negative returns for the portfolio; meanwhile, the mean-variance approach indicates an aversion to both positive and negative deviations in returns. With a high discount rate, investors favor less capital-intensive technologies. To account for the impact of risk aversion in policy framework we, therefore, need more empirical work on understanding these behavioral traits of energy companies.