Policy uncertainty and electric utility investments

We extend the existing literature on policy uncertainty by distinguishing between policy ambiguity and risk. Policy ambiguity involves uncertainty that cannot be quantified due to lack of historical precedent. Policy risk (or volatility) arises from uncertainty about future government actions that can be quantified in terms of probabilities based on the composition of legislative bodies and statements from elected officials. We use a real options model to show that policy risk can increase investment if the volatility is associated with stick policies such as carbon pricing and technology regulations. Using firm-level data on the electric utility industry, we show that a commonly-used measure of policy uncertainty that includes both ambiguity and risk is associated with decreased utility investment. However, policy risk is associated with increased utility investment consistent with a history of command-and-control regulations in the utility industry.