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Option Value of Emission Allowances

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  • Chao, Hung-Po
  • Wilson, Robert

Abstract

We study the market for emission allowances stipulated in the 1990 Clean Air Act Amendment. We assume that the number of allowances is fixed and that demand is affected by a stochastic parameter that follows a Wiener process ('Brownian motion'). The optimal investment policy for scrubbers is characterized. Investments in scrubbers are reduced if there is greater uncertainty about future market conditions. This is because purchases of emission allowances provide flexibility to adapt to demand conditions in a way that installing scrubbers does not. The price of emission allowances may therefore exceed the marginal cost of scrubbers by an amount called the option value. We derive an explicit formula for the option value and present computational results to illustrate its likely magnitude. Copyright 1993 by Kluwer Academic Publishers

Suggested Citation

  • Chao, Hung-Po & Wilson, Robert, 1993. "Option Value of Emission Allowances," Journal of Regulatory Economics, Springer, vol. 5(3), pages 233-249, September.
  • Handle: RePEc:kap:regeco:v:5:y:1993:i:3:p:233-49
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    References listed on IDEAS

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    1. Mandy, David M, 2000. "Killing the Goose That May Have Laid the Golden Egg: Only the Data Know Whether Sabotage Pays," Journal of Regulatory Economics, Springer, vol. 17(2), pages 157-172, March.
    2. Jean Tirole, 1988. "The Theory of Industrial Organization," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262200716, January.
    3. Buehler, Stefan & Schmutzler, Armin & Benz, Men-Andri, 2004. "Infrastructure quality in deregulated industries: is there an underinvestment problem?," International Journal of Industrial Organization, Elsevier, vol. 22(2), pages 253-267, February.
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    5. Weisman, Dennis L & Kang, Jaesung, 2001. "Incentives for Discrimination when Upstream Monopolists Participate in Downstream Markets," Journal of Regulatory Economics, Springer, vol. 20(2), pages 125-139, September.
    6. David Mandy & David Sappington, 2007. "Incentives for sabotage in vertically related industries," Journal of Regulatory Economics, Springer, pages 235-260.
    7. Severin Borenstein, 2002. "The Trouble With Electricity Markets: Understanding California's Restructuring Disaster," Journal of Economic Perspectives, American Economic Association, vol. 16(1), pages 191-211, Winter.
    8. Newbery, David M., 1997. "Privatisation and liberalisation of network utilities," European Economic Review, Elsevier, vol. 41(3-5), pages 357-383, April.
    9. Reiffen, David, 1998. "A Regulated Firm's Incentive to Discriminate: A Reevaluation and Extension of Weisman's Result," Journal of Regulatory Economics, Springer, vol. 14(1), pages 79-86, July.
    10. Economides, Nicholas, 1998. "The incentive for non-price discrimination by an input monopolist," International Journal of Industrial Organization, Elsevier, vol. 16(3), pages 271-284, May.
    11. Spence, A Michael, 1977. "Nonprice Competition," American Economic Review, American Economic Association, vol. 67(1), pages 255-259, February.
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