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Evaluating the power investment options with uncertainty in climate policy

Author

Listed:
  • Yang, Ming
  • Blyth, William
  • Bradley, Richard
  • Bunn, Derek
  • Clarke, Charlie
  • Wilson, Tom

Abstract

This paper uses a real options approach (ROA) for analysing the effects of government climate policy uncertainty on private investors' decision-making in the power sector. It presents an analysis undertaken by the International Energy Agency (IEA) that implements ROA within a dynamic programming approach for technology investment choice. Case studies for gas, coal and nuclear power investment are undertaken with the model. Illustrative results from the model indicate four broad conclusions: i) climate change policy risks can become large if there is only a short time between a future climate policy event such as post-2012 and the time when the investment decision is being made; ii) the way in which CO2 and fuel price variations feed through to electricity price variations is an important determinant of the overall investment risk that companies will face; iii) investment risks vary according to the technology being considered, with nuclear power appearing to be particularly exposed to fuel and CO2 price risks under various assumptions; and iv) the government will be able to reduce investors' risks by implementing long-term (say 10 years) rather than short-term (say 5 years) climate change policy frameworks. Contributions of this study include: (1) having created a step function with stochastic volume of jump at a particular time to simulate carbon price shock under a particular climate policy event; (2) quantifying the implicit risk premium of carbon price uncertainty to investors in new capacity; (3) evaluating carbon price risk alongside energy price risk in investment decision-making; and (4) demonstrating ROA to be a useful tool to quantify the impacts of climate change policy uncertainty on power investment.

Suggested Citation

  • Yang, Ming & Blyth, William & Bradley, Richard & Bunn, Derek & Clarke, Charlie & Wilson, Tom, 2008. "Evaluating the power investment options with uncertainty in climate policy," Energy Economics, Elsevier, vol. 30(4), pages 1933-1950, July.
    • Handle: RePEc:eee:eneeco:v:30:y:2008:i:4:p:1933-1950
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    References listed on IDEAS

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    1. Avinash K. Dixit & Robert S. Pindyck, 1994. "Investment under Uncertainty," Economics Books, Princeton University Press, edition 1, number 5474, December.
    2. Marreco, Juliana de Moraes & Carpio, Lucio Guido Tapia, 2006. "Flexibility valuation in the Brazilian power system: A real options approach," Energy Policy, Elsevier, vol. 34(18), pages 3749-3756, December.
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    6. Laurikka, Harri, 2006. "Option value of gasification technology within an emissions trading scheme," Energy Policy, Elsevier, vol. 34(18), pages 3916-3928, December.
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