Participants’ treatment of allowance price uncertainty: how are risk-aversion and real option values related to each other?

Abstract

The way in which participants of a tradable allowance system treat the allowance price uncertainty has so far been analysed either as reductions in “market exposure” resulting from risk-aversion, or as “wait-and-see” strategies in the sense of real option theory. This paper analyses how these two reactions could interact. The following conclusions can be drawn from this integration under the assumptions that participants are at least on aggregate risk-averse, that relative market positions (seller or buyer) are a result of differences in abatement cost and not of systematic differences in risk-attitude, that investments are to a significant degree irreversible, and that no dominant “flipping” of buyers becoming sellers occurs: Under free allocation according to historic emissions, a higher price risk is likely to lead to an aggregate reduction of abatement investment at any point in time. Innovative investment (i.e, investment employing new technologies) is also reduced, plausibly to an even stronger extent than investment in general. Auctioning generally leads to higher abatement investment than free allocation under risky allowance prices, since under auctioning all agents are “buyers” in the market. The overall effect of price risk on abatement investment is ambiguous under auctioning and depends on the relative importance of the revenues lost while “waiting-in-line”, compared to the option value of waiting, which depends on the relative importance of the “random” price factors.