The Logic of Carbon Risk from the Investor's Perspective: The Expected Carbon Payment

Abstract

This paper uses survey data to create a model of carbon risk (the financial risk associated with CO2 emissions under uncertain climate change policy). The usual way to incorporate the notion of carbon risk into investment decision making is to include a cost of carbon in the budget analysis. Most existing literature uses the expected price of carbon as a proxy for this cost, often represented by the price of traded permits, in its modeling of power plant investment decisions. In contrast, this paper introduces the idea of expected payment of carbon as a more accurate measure of carbon cost as perceived by industry practitioners. This measure of carbon risk incorporates both 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 2007-9. 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 be important for future policy debates.