Investment, Tobin’s q, and the stochastic price of fossil fuel

Fossil fuel power companies’ production exposes them to carbon risk. Despite extensive empirical research on carbon risk impacts, theoretical frameworks embedding stochastic fossil fuel price dynamics into corporate investment decisions remain scarce. We address this gap by examining the impact of stochastic fossil fuel prices on corporate investment and firm value within a neoclassical q-theoretic framework. We show that stochastic fossil fuel prices have important implications for investment and Tobin’s q. Quantitatively, fluctuations in fossil fuel prices once drove the average q value down below unity, and a firm that ignores price volatility may misallocate investments, leading to a potential reduction in firm value by more than 42%. Value erosion exhibits disproportionate intensity decay, with a halved investment–capital ratio associated with an already 32% depletion. Qualitatively, fossil fuel price volatility persistently depresses Tobin’s q, inducing strategic disinvestment as firms postpone capital expenditures to mitigate uncertainty. We use duration to quantify the sensitivity of firm value to price volatility, decomposing assets-in-place and growth opportunities. Finally, we generalize the model to incorporate asymmetric adjustment costs and irreversibility. We find that inaction is optimal response which are pertinent to empirical analysis, especially when firms face high capital adjustment costs. Our model suggests that firms should integrate fossil fuel price volatility into strategy to mitigate risks associated with carbon regulation and market fluctuations.