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Optimal fuel-mix in CHP plants under a stochastic permit price: Risk-neutrality versus risk-aversion

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  • Lappi, Pauli
  • Ollikka, Kimmo
  • Ollikainen, Markku
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    Abstract

    This paper studies the optimal fuel-mix of a CHP producer under emission permit price risk. The producer's multi-fuel plant uses two CO2-intensive fuels and one clean fuel. Using a mean-variance framework we develop three models. The models are divided into spot-models (risk neutral and risk averse cases) and a forward-model (risk averse case). We derive the effects of price risk on optimal fuel use. An increase in price risk can in fact increase the use of CO2-intensive fuel in the spot-model. In the forward-model, the production and financial decisions are separate. We also evaluate the risk-bearing behavior of seven Finnish CHP producers. We found that risk-neutrality describes behavior better than risk-aversion.

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    Bibliographic Info

    Article provided by Elsevier in its journal Energy Policy.

    Volume (Year): 38 (2010)
    Issue (Month): 2 (February)
    Pages: 1079-1086

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    Handle: RePEc:eee:enepol:v:38:y:2010:i:2:p:1079-1086

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    Web page: http://www.elsevier.com/locate/enpol

    Related research

    Keywords: Emissions trading Fuel substitution Risk-aversion;

    References

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    1. Richard Green, 2007. "Carbon Tax or Carbon Permits: The Impact on Generators' Risks," Discussion Papers 07-02, Department of Economics, University of Birmingham.
    2. Baldursson, Fridrik M & von der Fehr, N.-H.M.Nils-Henrik M, 2004. "Price volatility and risk exposure: on market-based environmental policy instruments," Journal of Environmental Economics and Management, Elsevier, vol. 48(1), pages 682-704, July.
    3. Holthausen, Duncan M, 1979. "Hedging and the Competitive Firm under Price Uncertainty," American Economic Review, American Economic Association, vol. 69(5), pages 989-95, December.
    4. Roques, Fabien A. & Newbery, David M. & Nuttall, William J., 2008. "Fuel mix diversification incentives in liberalized electricity markets: A Mean-Variance Portfolio theory approach," Energy Economics, Elsevier, vol. 30(4), pages 1831-1849, July.
    5. Soderholm, Patrik, 2001. "Fossil fuel flexibility in west European power generation and the impact of system load factors," Energy Economics, Elsevier, vol. 23(1), pages 77-97, January.
    6. Blair, Roger D, 1974. "Random Input Prices and the Theory of the Firm," Economic Inquiry, Western Economic Association International, vol. 12(2), pages 214-26, June.
    7. Tsiang, S C, 1972. "The Rationale of the Mean-Standard Deviation Analysis, Skewness Preference, and the Demand for Money," American Economic Review, American Economic Association, vol. 62(3), pages 354-71, June.
    8. Gotham, Douglas & Muthuraman, Kumar & Preckel, Paul & Rardin, Ronald & Ruangpattana, Suriya, 2009. "A load factor based mean-variance analysis for fuel diversification," Energy Economics, Elsevier, vol. 31(2), pages 249-256, March.
    9. Machina, Mark J, 1987. "Choice under Uncertainty: Problems Solved and Unsolved," Journal of Economic Perspectives, American Economic Association, vol. 1(1), pages 121-54, Summer.
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