Investment under uncertain climate policy: A practitioners׳ perspective on carbon risk

Abstract

This paper introduces the concept of payment probability as an important component of carbon risk (the financial risk associated with CO2 emissions under uncertain climate policy). In modeling power plant investment decisions, most existing literature uses the expected carbon price (e.g., the price of traded permits or carbon tax) as a proxy for carbon risk. In contrast, this paper identifies expected carbon payment as a more accurate measure of carbon risk as perceived by industry practitioners. This measure of carbon risk incorporates both expected price and the probability that this price would actually be faced in the case of a particular investment. This concept helps explain both the surge of activity in 2005–2006 and the subsequent decline in interest in coal-fired power plant development in the U.S. The data for this case study comes from an extensive online survey of 700 U.S. energy professionals completed in 2006, as well as interviews conducted with industry representatives from 2007 to 2009. By analyzing industry views on policy uncertainty and future carbon legislation, we gain a better understanding of investor attitudes toward carbon risk. This understanding will help policy makers design better incentives for investing in low-carbon technologies.