Irreversible Investment under Regime-Switching Carbon Policy: An Analytical Real Options Model

In this paper regime switching real options framework is created to examine the irreversible investment with uncertain carbon policy. The model includes low and high transition between low- and high-carbon tax regimes and it represents both market uncertainty and regulatory uncertainty. The output prices with diffusion and the policy with a continuous time Markov chain are followed. Continuation value expressions are obtained and value-matching and smooth-pasting conditions are used to characterize regime dependent investment thresholds. Through the analysis, the existence and uniqueness of optimal triggers are established, and its sensitivity to carbon taxation and the intensity of a policy switch are determined. Empirical evidence indicates that, under the high tax regime, carbon taxes deter investment and increase thresholds; and inequality in the policy regime increases the distance between regime-specific triggers. The impact of switching intensity is non-monotonic: medium levels of uncertainty cause the option value of waiting to rise, whilst high levels of switching cause thresholds to fall. The results point to relevance of carbon policy and regulatory stability when making investment decisions.