Technology Choice under Emission Regulation Uncertainty in International Container Shipping

We present a real options approach to evaluate technology and capacity choices under regulatory uncertainty. Our two-phase, regime-switching model includes the option of investing in different technologies as well as a charter and layup option, respectively. For a base-case version of this model, we derive an analytical solution before studying the effect of regulatory uncertainty in a numerical extension that relaxes certain restrictive assumptions. We then describe three regulatory regimes, an emissions cap, an emissions tax and a cap-and-trade market, and compare how effectively each reduces emissions. Applying the model to maritime container shipping, we develop insights on the optimal technology choice for reducing SOx emissions. We find that regulatory uncertainty can increase not only project values but also owned capacity. From a regulatory perspective, an emissions cap reduces emissions more effectively whereas an emissions tax reduces the cost of regulation. The cap-and-trade market emerges in many respects as superior to an emissions tax. Finally, we show that setting the emissions cap level—or deciding on the level above which an emissions tax or emissions trade apply—is critical because reduction in total industry emissions are not necessarily continuous.