Abstract
We study the impact of emissions tax and emissions cap-and-trade regulation on a firm's technology choice and capacity decisions. We show that emissions price uncertainty under cap-and-trade results in greater expected profit than a constant emissions price under an emissions tax, which contradicts popular arguments that the greater uncertainty under cap-and-trade will erode value. We further show that two operational drivers underlie this result: i) the firm's option not to operate, which effectively right-censors the uncertain emissions price; and ii) dispatch flexibility, which is the firm's ability to first deploy its most profitable capacity given the realized emissions price. In addition to these managerial insights, we also explore policy implications: the effect of emissions price level, and the effect of investment and production subsidies. Through an illustrative example, we show that production subsidies of higher investment and production cost technologies (such as carbon capture and storage technologies) have no effect on the firm's optimal total capacity when firms own a portfolio of both clean and dirty technologies, but that investment subsidies of these technologies increase the firm's total capacity, conditionally increasing expected emissions. A subsidy of a lower production cost technology, on the other hand, has no effect on the firm's optimal total capacity in multi-technology portfolios, regardless of whether the subsidy is a production or investment subsidy.
Highlights
Cap-and-trade emissions regulation was implemented in Europe in 2005 under the European Union Emissions Trading Scheme (EU-ETS)
We show that production subsidies of higher investment and production cost technologies have no effect on the firm’s optimal total capacity when firms own a portfolio of both clean and dirty technologies, but that investment subsidies of these technologies increase the firm’s total capacity, conditionally increasing expected emissions
Expected profit increases due to dispatch flexibility—the firm’s ability to choose what capacity to deploy and what capacity to hold in reserve—if three conditions are met: i) the firm’s capacity portfolio consists of both technology types; ii) expected utilization is less than 100%—i.e., there is a non-zero probability that total capacity exceeds demand; and iii) each type is preferred in merit order at some emissions price over the support of e
Summary
Cap-and-trade emissions regulation was implemented in Europe in 2005 under the European Union Emissions Trading Scheme (EU-ETS). Given the capital intensity of emissions regulated sectors, investment decisions such as the technologies that firms choose when building capacity are of principal interest. Kleindorfer, and Van Wassenhove: Capacity Portfolios under Emissions Regulation determine how firms trade off traditional operating and investment costs with emissions intensity (i.e., the emissions generated per unit of production). A firm’s emissions intensity determines its exposure to uncertain allowance prices if they are regulated by a cap-and-trade regime, or a constant unit emissions cost under an emissions tax. We study capacity portfolio and production decisions under both an emissions tax and an emissions cap-and-trade regime. We illustrate the context-dependent effect this has on total expected emissions through an example grounded in electric power generation
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