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Hedging Strategies: Electricity Investment Decisions under Policy Uncertainty

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  • Jennifer F. Morris
  • Vivek Srikrishnan
  • Mort D. Webster
  • John M. Reilly

Abstract

Given uncertainty in long-term carbon reduction goals, how much non-carbon generation should be developed in the near-term? This research investigates the optimal balance between the risk of overinvesting in non-carbon sources that are ultimately not needed and the risk of underinvesting in non-carbon sources and subsequently needing to reduce carbon emissions dramatically. We employ a novel framework that incorporates a computable general equilibrium (CGE) model of the U.S. into a two-stage stochastic approximate dynamic program (ADP) focused on decisions in the electric power sector. We solve the model using an ADP algorithm that is computationally tractable while exploring the decisions and sampling the uncertain carbon limits from continuous distributions. The results of the model demonstrate that an optimal hedge is in the direction of more non-carbon investment in the near-term, in the range of 20-30% of new generation. We also demonstrate that the optimal share of non-carbon generation is increasing in the variance of the uncertainty about the long-term carbon targets, and that with greater uncertainty in the future policy regime, a balanced portfolio of non-carbon, natural gas, and coal generation is desirable.

Suggested Citation

  • Jennifer F. Morris & Vivek Srikrishnan & Mort D. Webster & John M. Reilly, 2018. "Hedging Strategies: Electricity Investment Decisions under Policy Uncertainty," The Energy Journal, , vol. 39(1), pages 101-122, January.
    • Handle: RePEc:sae:enejou:v:39:y:2018:i:1:p:101-122
    DOI: 10.5547/01956574.39.1.jmor
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    1. Alan S. Manne, 1960. "Linear Programming and Sequential Decisions," Management Science, INFORMS, vol. 6(3), pages 259-267, April.
    2. Alan Manne & Richard Richels, 1992. "Buying Greenhouse Insurance: The Economic Costs of CO2 Emission Limits," MIT Press Books, The MIT Press, edition 1, volume 1, number 026213280x, April.
    3. Crost, Benjamin & Traeger, Christian P., 2010. "Risk and Aversion in the Integrated Assessment of Climate Change," CUDARE Working Papers 90935, University of California, Berkeley, Department of Agricultural and Resource Economics.
    4. Hertel, Thomas, 1997. "Global Trade Analysis: Modeling and applications," GTAP Books, Center for Global Trade Analysis, Department of Agricultural Economics, Purdue University, number 7685, December.
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    Cited by:

    1. Bergen, Matías & Muñoz, Francisco D., 2018. "Quantifying the effects of uncertain climate and environmental policies on investments and carbon emissions: A case study of Chile," Energy Economics, Elsevier, vol. 75(C), pages 261-273.

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    More about this item

    Keywords

    Energy policy; Uncertainty; Electricity; Investment; Emissions; General equilibrium; Approximate dynamic programming;
    All these keywords.

    JEL classification:

    • F0 - International Economics - - General

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