The effectiveness of carbon pricing: the role of diversification in a firm's investment decision

Tine Compernolle; Peter Kort; Jacco Thijssen

doi:10.1016/j.eneco.2022.106115

The effectiveness of carbon pricing: the role of diversification in a firm's investment decision

Tine Compernolle, Peter Kort, Jacco Thijssen

Mathematics

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Abstract

It is often argued that compared to a carbon tax, a volatile carbon price under an emissions trading system poses a problem in the transition towards a low carbon economy. However, this paper shows that, when sufficiently positively correlated with the electricity price, carbon price uncertainty diminishes overall volatility because of a diversification effect. To get this result, we develop a dynamic real options model to analyze the impact of positively correlated price uncertainty on the timing of an investment decision. In contrast to static models, we show that even when the carbon price is initially the same under both policy instruments, the timing of the investment decision will typically be different. More importantly, we find that multiple correlated price uncertainties under an emissions trading system encourages investment more than less uncertainty under a carbon tax. Hence, to stimulate a low carbon (or discourage a carbon intensive) investment, an emissions trading system (carbon tax) is preferred. The policy reverts for higher levels of uncertainty and low correlations.

Original language	English
Article number	106115
Number of pages	10
Journal	Energy economics
Volume	112
Early online date	23 Jun 2022
DOIs	https://doi.org/10.1016/j.eneco.2022.106115
Publication status	Published - 15 Aug 2022

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10.1016/j.eneco.2022.106115

ENEECO-D-20-01020R3
© 2022 Elsevier B.V. This is an author-produced version of the published paper. Uploaded in accordance with the publisher’s self-archiving policy.
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Cite this

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abstract = "It is often argued that compared to a carbon tax, a volatile carbon price under an emissions trading system poses a problem in the transition towards a low carbon economy. However, this paper shows that, when sufficiently positively correlated with the electricity price, carbon price uncertainty diminishes overall volatility because of a diversification effect. To get this result, we develop a dynamic real options model to analyze the impact of positively correlated price uncertainty on the timing of an investment decision. In contrast to static models, we show that even when the carbon price is initially the same under both policy instruments, the timing of the investment decision will typically be different. More importantly, we find that multiple correlated price uncertainties under an emissions trading system encourages investment more than less uncertainty under a carbon tax. Hence, to stimulate a low carbon (or discourage a carbon intensive) investment, an emissions trading system (carbon tax) is preferred. The policy reverts for higher levels of uncertainty and low correlations.",

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