Price Dynamics in the EU ETS and Evaluation of Its Ability to Boost Emission-Related Investment Decisions

Abstract

We assess the effects of the European Union emission trading scheme (EU ETS) in delivering low-carbon investments at the firm level, by modeling a price taker electricity producer subject to the EU ETS jurisdiction. We compute, via Least Squares Monte Carlo (LSMC) methods, the value of the real option the greenhouse gas emitter has, consisting in the opportunity to switch from its current high-carbon technology to a cleaner one. We evaluate this real option by proposing an extension to the model presented by Brauneis et al, introducing a different stochastic process, both for fuel and carbon prices, in place of the geometric brownian motion (GBM). Specifically, we propose a Brennan-Schwarz model, which exhibits positive mean-reverting prices, for fuel and a Variance Gamma (VG) specification for carbon prices. Moreover, we further analyze the investment decision problem, in case of a CO2 price stabilization mechanism, by explicitly computing the expected value of the investment project by means of Fourier methods. Our results show that the introduction of a price stabilization mechanisms, in this case a carbon floor price, significantly affects the timing of the investment decision, supporting emission related investments.