Regulated correlations — Climate policy and investment risks

Investments in energy technologies are substantially governed by climate policy. We demonstrate analytically that price-based instruments, such as carbon-taxes, and quantity-based regulations, like emission trading, have distinct effects on the (co-) variance of power plant profits. If investors are risk-averse, this leads to divergent technology portfolios, breaking the equivalence of price- and quantity-based policy instruments under risk-neutrality. Using a calibrated stochastic electricity market model, risk aversion leads to lower baseline emissions, causing emissions trading to reduce less emissions than a carbon tax equivalent under risk neutrality. However, the welfare costs of carbon taxes rise with increasing risk aversion. Uncertainty about the stringency of carbon taxes leads to lower shares of fossil fuel assets with increasing risk aversion.