Business responses to climate policy uncertainty: Theoretical analysis of a twin deferral strategy and the risk-adjusted price of carbon
Graphical abstract
Introduction
The challenge of decarbonizing the global economy to a large extent relies on private sector investment decisions. Nevertheless, without clear and long-term climate policies, private business is not ready to commit the necessary scale of resources to lower-emitting technologies and practices. In the absence of policy, premature decarbonization can erode existing comparative advantages and reduce long-term returns. Global greenhouse gas emissions continue rising despite broad scientific recognition of the global and regional risks associated with climate change, public support of climate action, progress on international negotiations, and advances in low-carbon technologies and energy efficiency solutions [1]. This increasing gap between current emissions and the pathway needed to achieve global climate stability indicates that private businesses are largely reluctant to take aggressive action in the face of uncertain climate policy in much of the world.
The distinctly negative effect of uncertainty on investment is well established [[2], [3], [4]]. Both applied research and empirical evidence provide broad support for this relationship. For example, Gulen and Ion [5] find that policy uncertainty depresses corporate investment, as firms delay decisions as a precautionary strategy when faced with irreversible commitments. Phan [6] similarly illustrates how crude oil price uncertainty negatively influences corporate investment. Drobetz et al. [7] connects policy uncertainty increases with cost of capital.
Real options analysis (ROA) provides a theoretical framework for understanding the impact of uncertainty on irreversible investment. Uncertainty creates a risk premium for investment equal to the value of waiting to obtain more information, alternatively known as the value of a “deferral option” (i.e. the option to defer an investment or other irreversible decision). The relationship is proportional, such that a higher degree of uncertainty results in higher value of the deferral option. Premature investment in assets, such as low-carbon technologies, with uncertain returns could result in losses in the deferral option value. Originally proposed by Dixit and Pindyck [4], ROA quickly became a leading analytical tool for investment decisions under uncertainty [[8], [9], [10]].
In context of climate and energy policy, Pindyck [3] established the value of a deferral option on investment in greenhouse gas (GHG) abatement (emissions reductions) when climate benefits are uncertain. Anda et al. [11] focuses on the option value of climate policy and considers a tradeoff between irreversible damages attributed to climate change and potential losses from irreversible investment in abatement. Golub et al. [12] show connections between the ROA, dynamic stochastic optimization, and event tree analysis in the Integrated Assessment Models (IAMs). Further, Blyth et al. [13], Fuss et al. [14,15], Szolgayová et al. [16] and Dalby et al. [17] agree that uncertainty suppresses investment in low carbon technologies. Dorsey, J [18]. presents empirical evidence of low investment in pollution abatement in response to uncertainty. Jiang et al. [19] find that the policy uncertainty affects US carbon emissions for all sectors. Barradale [20] describes a similar negative effect of public policy uncertainty on investment in US wind power production. Zhang et al. [21], Botta [22], Golub et al. [23], Golub [24], Liu et al. [25] all provide further information on different aspects of policy uncertainty and their influence on investment decision, cost of capital, and economic growth.
ROA is a powerful and well-established methodology to quantify investment risks when an anticipated return on investment is uncertain. The real option value is additional to the anticipated return on investment and could therefore be included in conventional benefit-cost analysis [26]. Instead of maximizing the expected return, a corporation maximizes a risk-adjusted return: the value of an investment project, with or without flexibility. A premature commitment to an irreversible investment decision would erode flexibility but would generate an immediate return. The value of lost flexibility can be estimated as the value of a lost deferral option. On the other hand, if a corporation delays an irreversible decision, the value of the deferral option would be preserved but at the expense of lost revenues. The loss due to delayed revenues can be interpreted as a type of payment to maintain the deferral option.
The application of ROA provides an explanation for why corporations refrain from investing in low-carbon technologies, as well as from investments to buy and hold (“bank”) allowances (emissions permits) in the context of GHG emissions trading systems [27,28] demonstrate how lagging investment in abatement technologies and lack of banking may eventually result in an abatement “short squeeze” in which carbon prices will be sharply pushed upwards as carbon-intensive firms rush to cover emissions liabilities they have in effect accumulated in anticipation of falling carbon prices.
In existing literature, climate policy uncertainty is usually associated with uncertain dynamics of carbon price [[13], [14], [15]]. For modeling investment decisions, an exogenous uncertain carbon price typically serves as a proxy for uncertain climate policy. In contrast, in Golub et al. [27] the global emission target is an exogenous parameter, while the carbon price and its associated level of uncertainty are endogenous. Treating the carbon price as an endogenous parameter allows for a more sophisticated analysis of how regulated firms respond to policy uncertainty and how this affects the dynamics of the carbon price. The analysis in this paper treats carbon prices as endogenous and contributes to the existing literature on carbon pricing by providing an in-depth analysis of the driving forces behind carbon price dynamics under uncertainty, leading to a predicted stepwise rising trajectory of carbon prices.
This paper studies the interaction of an uncertain future emission target and current demand for abatement that in turn determine the price of GHG emissions permits (the carbon price). This paper develops a conceptual model of firm behavior to predict a twin deferral strategy that consists of a tendency to defer investments in abatement as well as in effectively building an abatement reserve by banking carbon allowances or emission reduction credits (e.g. “offsets”) that could be used to cover emissions and thus avoid abatement in the future. Further, this paper demonstrates how this strategy leads to a predicted carbon price trajectory that rises over time in a stepwise manner. Additionally, the analysis highlights a strong relationship between the magnitude of policy uncertainty and the degree of suppression of the current (spot as opposed to futures market) carbon price and its likely need to correct upwards in the future.
In addition to this analysis of driving forces behind carbon prices, this paper provides a secondary contribution to existing literature with an analysis of a potential hedging strategy for firms exposed to future carbon prices. While the twin deferral strategy creates a risk that firms will face a shortfall of abatement, corporations may mitigate this risk by establishing a counterbalancing long position on low-cost abatement, by purchasing call options with a relatively high strike price.1 In particular, Reducing Emissions from Tropical Deforestation and forest Degradation (REDD+) likely offers the largest global potential to immediately create a sizable abatement reserve that can underpin such call options, helping businesses to manage the risk of an abatement short squeeze without compromising the net global abatement target [27,28].
Section 2 (methodology) presents theoretical model and findings, using a graphical illustration as well as closed-form solution. Section 3 (results and discussion) applies these findings with a numerical example to discuss the price dynamics of international carbon markets and proposes hedging policy. Section 4 concludes with further implications of these findings.
Section snippets
Methodology for policy uncertainty and firms’ abatement strategy analysis
This section considers a stylized partial equilibrium problem for a firm that depends heavily on the use of fossil fuels and must decide how to manage the uncertain possibility that it may eventually face a transition cost of adjusting to future climate policy. The firm has several abatement alternatives but all of them require significant upfront investments at risk of becoming prematurely devalued or “stranded” assets if significant climate policy does not materialize in time. The estimated
Stepwise carbon price dynamics
Next, partial resolution of policy uncertainty is shown to result in a stepwise shape for an equilibrium carbon price as a function of time. First, equation (1) can be rewritten as follows:where:
Since is negative, theoretically, could be negative too. Higher policy uncertainty around is captured by higher and thus higher value of , which
Conclusions
This paper develops a conceptual model of the behavior of a risk-neutral firm facing emissions control liabilities in the face of uncertain future climate policies. In contrast to previous studies that assume risk averse behavior, this paper examines how a firm facing policy uncertainty must trade off expected payoffs from being long with the expected payoffs of being short on abatement. Even if the firm is risk neutral over its future profits, nonlinearities in the profit function are
Declaration of competing interest
The authors declare that they have no known competing financial interests or personal relationships that could have appeared to influence the work reported in this paper.
Acknowledgments
We are grateful to Margaret McCallister (EDF) and Diego Herrera García (The World Bank) for significant help with preparation and revision of the manuscript. We also acknowledge helpful comments and insights from Grzegorz Peszko (The World Bank), Sergey Paltsev (MIT), three anonymous referees, and participants of the 6th World Congress of Environmental and Resource Economists, International Energy Workshop, and Carbon Price Leadership Coalition conferences. All remaining errors are our own. The
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