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Hedging Strategies: Electricity Investment Decisions under Policy Uncertainty

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  • Jennifer Morris
  • Vivek Srikrishnan
  • Mort Webster
  • John Reilly

Abstract

Given uncertainty in long-term carbon reduction goals, how much non-carbon generation should be developed in the near-term? This research investigates the optimal balance between the risk of overinvesting in non-carbon sources that are ultimately not needed and the risk of underinvesting in non-carbon sources and subsequently needing to reduce carbon emissions dramatically. We employ a novel framework that incorporates a computable general equilibrium (CGE) model of the U.S. into a two-stage stochastic approximate dynamic program (ADP) focused on decisions in the electric power sector. We solve the model using an ADP algorithm that is computationally tractable while exploring the decisions and sampling the uncertain carbon limits from continuous distributions. The results of the model demonstrate that an optimal hedge is in the direction of more non-carbon investment in the near-term, in the range of 20-30% of new generation. We also demonstrate that the optimal share of non-carbon generation is increasing in the variance of the uncertainty about the long-term carbon targets, and that with greater uncertainty in the future policy regime, a balanced portfolio of non-carbon, natural gas, and coal generation is desirable.

Suggested Citation

  • Jennifer Morris & Vivek Srikrishnan & Mort Webster & John Reilly, 2018. "Hedging Strategies: Electricity Investment Decisions under Policy Uncertainty," The Energy Journal, International Association for Energy Economics, vol. 0(Number 1).
    • Handle: RePEc:aen:journl:ej39-1-morris
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    Cited by:

    1. Bergen, Matías & Muñoz, Francisco D., 2018. "Quantifying the effects of uncertain climate and environmental policies on investments and carbon emissions: A case study of Chile," Energy Economics, Elsevier, vol. 75(C), pages 261-273.
    2. Sabani, Nazmie & Bales, Stephan & Burghof, Hans-Peter, 2024. "On the different impact of local and national sources of policy uncertainty on sectoral stock volatility," Research in International Business and Finance, Elsevier, vol. 72(PB).

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