Joint decisions on emission reduction and order quantity by a risk-averse firm under cap-and-trade regulation

Abstract

With the implementation of carbon regulations, firmes are facing pressure on emission reduction and need to consider investing in clean equipment and technology to reduce carbon emissions. However, the resulting uncertainty poses risks to operation management, and decision-makers have different risk preferences. This paper considers a risk-averse firm confronted with cap-and-trade regulation and uncertain market demand. The customers are assumed to be environment-friendly, and thus the demand is influenced by carbon emissions. The joint decisions on order quantity and emission reduction levels are investigated under the conditional value-at-risk (CVaR) framework. This research formulates a joint decision model based on the CVaR criterion and explores how a firm’s risk aversion and investment coefficient influence optimal decisions. The findings show that if the investment coefficient of carbon emission reduction is sufficiently small, firms will not trade any carbon credits. This implies that for the effectiveness of the carbon market, the government should continue decreasing the carbon quota with the development of clean technologies. Additionally, the cap-and-trade regulation encourages firms to invest in carbon emission reduction and does not necessarily deplete the risk-averse firm's profit. Particularly, it is found that in the higher trading price of carbon, the optimal emission reduction level is more sensitive to risk aversion than to the order quantity.