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Investors’ reaction to the government credibility problem: A real option analysis of emission permit policy risk

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  • Kang, Sang Baum
  • Létourneau, Pascal

Abstract

In relation to creating a CO2 emission permit market, there are two types of climate change policy risks: (1) It is uncertain whether and when a cap-and-trade system will be implemented; and (2) once a policy is in place, there may be government credibility issues. This paper examines the effect of these policy risks on real option decisions of electric power plant investment. To model both an investment decision and generation flexibility, this study evaluates an exotic compound American option on multiple strips of European spread options through the implementation of least squares Monte Carlo simulation. Government credibility risk leads to more investment in “less green” resources and induces additional cash flow variation, which increases the average time to investment (value of waiting). However, in an extreme case, government credibility can actually hasten investment because the risk may be more favorable to electric power companies. Furthermore, if emission trading is planned to be implemented in the future (e.g., 2020), and the market believes that the probability of successful implementation is low, firms will build a “less green” plant early to benefit from the period before the green rule is applied.

Suggested Citation

  • Kang, Sang Baum & Létourneau, Pascal, 2016. "Investors’ reaction to the government credibility problem: A real option analysis of emission permit policy risk," Energy Economics, Elsevier, vol. 54(C), pages 96-107.
  • Handle: RePEc:eee:eneeco:v:54:y:2016:i:c:p:96-107
    DOI: 10.1016/j.eneco.2015.11.023
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    Cited by:

    1. Pascal Létourneau & Lars Stentoft, 2019. "Bootstrapping the Early Exercise Boundary in the Least-Squares Monte Carlo Method," Journal of Risk and Financial Management, MDPI, Open Access Journal, vol. 12(4), pages 1-21, December.
    2. Rogge, Karoline S. & Schleich, Joachim, 2018. "Do policy mix characteristics matter for low-carbon innovation? A survey-based exploration of renewable power generation technologies in Germany," Research Policy, Elsevier, vol. 47(9), pages 1639-1654.

    More about this item

    Keywords

    Government credibility; Climate change policy; Emission trading; Real option; Compound option; Least squares Monte Carlo simulation;

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • Q40 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Energy - - - General
    • Q50 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Environmental Economics - - - General

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