Downcycling in circular production through sustainable insurance under cap-and-trade regulation and carbon tariffs

This paper presents a contingent claim option model to explore downcycling in circular production under cap-and-trade regulations and carbon tariffs, within the context of sustainable insurance. By applying a capped call option, the model shows how a life insurer finances a manufacturer producing steel, slag, and pollutants, while explicitly assessing the manufacturer's risk under related climate policy regulations. The manufacturer under cap-and-trade regulations employs carbon capture, utilization, and storage (CCUS) to support downcycling in slag production while exporting steel and slag, subject to carbon and product tariffs. The findings reveal that increased downcycling enhances the manufacturer's equity but reduces economies of scope. On the other hand, higher carbon emissions lower both equity and economies of scope. A stricter cap in the cap-and-trade system improves equity and strengthens policyholder protection, while increased carbon and product tariffs negatively affect both. Thus, downcycling with CCUS and lower emissions is favorable for the manufacturer's equity. A stricter cap supports efforts to achieve SDG 7 (Affordable and Clean Energy), but carbon and product tariffs do not. For the insurer, a more stringent cap encourages sustainable insurance aligned with SDG 3 (Good Health and Well-Being), though higher tariffs diminish policyholder protection.