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A Real Option-Based Approach for CO2 Price Management

This paper discusses the significance of implementing a price on carbon dioxide emissions as a crucial part of effective climate change policy, responding to the challenges of air pollution and investment decisions faced by firms under emissions trading systems. By utilizing Real Option Theory, the study explores how price management mechanisms—such as price ceilings, floors, and collars—can influence optimal investment timing in clean technologies. The insights aim to assist regulators in fostering technological advances while managing CO2 pricing effectively.

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A Real Option-Based Approach for CO2 Price Management

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  1. A real option-based approach for CO2 price managementMichael Loretz, University of Graz November 25, 2010 RESOWI, SR 15.25 Michael Loretz

  2. Motivation • Any meaningful climate change policy has to put a price on carbon dioxide emissions (Stern (2006)) • Price of zero leads to air pollution • The introduction of prices induces people to economize in the use of these resources • Impact on investment decisions Michael Loretz

  3. Table of Contents • European Union Emissions Trading System • Introduction • Price Management - Theory • Price Management - Implementation • Investment Problem of the Firm • Methodological Approach Michael Loretz

  4. Table of Contents • European Union Emissions Trading System • Introduction • Price Management - Theory • Price Management - Implementation • Investment Problem of the Firm • Methodological Approach Michael Loretz

  5. Introduction • Single firm which has to comply with an emissions trading system • perfect competition • Firm faces investment decision between t and T • an investment enables the firm to switch to a“clean” technology (C) • without the investment the firm remains with the actual “dirty” technology (D) • Does the firm take care about the price of CO2-emissions when making an investment decision? Michael Loretz

  6. Introduction • Firm is concerned with uncertain future prices • Input prices • e.g. for an electricity producing firm: oil, gas, coal, emissions • Output prices • e.g. electricity price • Using Real Option Theory to value the investment decision leads to an optimal investment time • Is a regulator able to influence the optimal investment timing? • To push technological advance? Michael Loretz

  7. Price Management as Regulatory Option • Assumption • An emission trading system in form of a pure cap-and-trade system exists already • there are no price management mechanisms • Regulatory options • Price management • Price ceiling • Price floor • Price collar • Cap-and-Trade + Price Management = Hybrid System • Gruell& Taschini (2010), Murray et al. (2009), PwC(2009), Wood & Jotzo (2010) Michael Loretz

  8. Table of Contents • European Union Emissions Trading System • Introduction • Price Management - Theory • Price Management - Implementation • Investment Problem of the Firm • Methodological Approach Michael Loretz

  9. Price Management - Theory • price ceiling • maximum price Michael Loretz

  10. Price Management - Theory • price floor • minimum price Michael Loretz

  11. Price Management - Theory • price collar • fixed price range Michael Loretz

  12. Table of Contents • European Union Emissions Trading System • Introduction • Price Management - Theory • Price Management - Implementation • Investment Problem of the Firm • Methodological Approach Michael Loretz

  13. Price Management - Implementation • price ceiling (safety valve) • policy regulator sells an (un)limited amount of permits • carbon tax if price ceiling is reached • like an American call option for compliance units • allowance reserve • relaxing the maximum amount of offsets valid for compliance • regulator sells call options to firms willing to buy protection Michael Loretz

  14. Price Management - Implementation • price floor • policy regulator purchases an (un)limited amount of permits • similar to a subsidy • like an American put option for compliance units • reserve price at auctions • with subsequent purchasing of the policy regulator • regulator sells put options to firms willing to buy protection Michael Loretz

  15. Table of Contents • European Union Emissions Trading System • Introduction • Price Management - Theory • Price Management - Implementation • Investment Problem of the Firm • Methodological Approach Michael Loretz

  16. Investment Problem of the Firm • Firm faces investment decision between t and T • an investment enables the firm to switch to a“clean” technology (C) • without the investment the firm remains with the actual “dirty” technology (D) Michael Loretz

  17. Cash-Flow of the Technologies • cash-flows of the different periods represent the respective profits • profit = revenue - variable costs - fixed costs Michael Loretz

  18. Rationale for Regulatory Intervention • Target is a change of optimal investment timing, such that • is the optimal investment timing with regulatory policy • e.g. cap-and-trade with price floor/ceiling/collar • is the optimal investment timing without regulatory policy • i.e. pure cap-and-trade Michael Loretz

  19. Effect of regulatory policy on investment timing • Optimal investment time occurs earlier • i.e. technological advance is pushed by regulator InFra_CO2

  20. Investment Timing and American Options • The question of optimal investment timing is closely connected to American Option characteristics • there is no closed-form solution available • numerical solution procedures have to be adapted to solve the problem at hand • American option characteristics demand dynamic programming techniques Michael Loretz

  21. Table of Contents • European Union Emissions Trading System • Introduction • Price Management - Theory • Price Management - Implementation • Investment Problem of the Firm • Methodological Approach Michael Loretz

  22. Methodological Approach • Stochastic input/output price processes • Simulation of projects cash flows • using stochastic input/output prices • Dynamic Programming to solve for optimal investment timing • close similarity to characteristics of an American option • optimal timing of investment decision leads to maximum net present value • Central is the calculation of the expected conditional value Michael Loretz

  23. Methodological Approach • Least squares Monte Carlo (LSM) approach (Longstaff & Schwartz (2001)) • Monte Carlo simulation techniques • Backward dynamic programming techniques • Conditional expectation is estimated from cross-sectional information • Delivers the value of the real option and the optimal investment timing Michael Loretz

  24. Thank you! • Questions & Remarks Michael Loretz

  25. Literature • Copeland, T., & Antikarov, V. (2003). Real Options - A Practitioner's Guide. Thomson - Texere. • Dixit, A. K., & Pindyck, R. S. (1994). Investment under Uncertainty. Princeton University Press, Princeton, New Jersey. • Longstaff, F., & Schwartz, E. (2001). Valuing American options by simulation: a simple least-squares approach. Review of Financial Studies, 14(1), 113-147. Michael Loretz

  26. Literature • Cortazar, G., Gravet, M., & Urzua, J. (2008). The valuationofmultidimensional American real optionsusingthe LSM simulationmethod. Computers & Operations Research, 35(1), 113-129. • Fuss, S., Szolgayová, J., Khabarov, N., & Obersteiner, M. (2010). Renewablesandclimatechangemitigation: Irreversible energyinvestmentunderuncertaintyandportfolioeffects. EnergyPolicy, In Press, CorrectedProof. • Yang, M., Blyth, W., Bradley, R., Bunn, D., Clarke, C., & Wilson, T. (2008). Evaluatingthe power investmentoptionswithuncertainty in climatepolicy. Energy Economics, 30(4), 1933-1950. Michael Loretz

  27. Literature • Gruell, G., & Taschini, L. (2010). Cap-and-trade properties under different hybrid scheme designs. Journal of Environmental Economics and Management, In Press, Corrected Proof, -. • Murray, B. C., Newell, R. G., & Pizer, W. A. (2009). Balancing Cost and Emissions Certainty: An Allowance Reserve for Cap-and-Trade. Review of Environmental Economics and Policy, 3(1), 84-103. • PwC. (2009). Carbon Taxes vs Carbon Trading - Pros, cons and the case for a hybrid approach. Report prepared for the IETA, 1-30. • Wood, P., & Jotzo, F. (2010). Price Floors for Emissions Trading. FEEM Working Paper No. 382.2010. Michael Loretz

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