Investment risks under uncertain climate change policy

• Published in: Energy policy Vol. 35; no. 11; pp. 5766 - 5773
• Main Authors: Blyth, William, Bradley, Richard, Bunn, Derek, Clarke, Charlie, Wilson, Tom, Yang, Ming
• Format: Journal Article
• Language: English
• Published: Oxford Elsevier Ltd 01.11.2007; Elsevier; Elsevier Science Ltd
• Series: Energy Policy
• Subjects: Applied sciences; Carbon; Climate change; Climate policy; Coal-fired power plants; Decision making; Decision making models; Economic data; Electric energy; Electricity; Electricity generation; Energy; Energy economics; Energy policy; Environmental economics; Environmental policy; Exact sciences and technology; General, economic and professional studies; Global warming; Investment; Methodology. Modelling; Real options analysis; Regulation; Regulatory risk; Risk factors; Risk management; Risk premiums; Studies; Uncertainty; Decision-making; Electricity; Regulatory risk; Company; Uncertainty; Gas fired power station; Decision making; Pollution control; Pollution prevention; CO2 sequestration; Risk analysis; Energy industry; Combined cycle; Coal power plant; Financial option; Regulation policy; Electric power production; Private sector; Investment
• DOI: 10.1016/j.enpol.2007.05.030
• ISSN: 0301-4215

This paper describes results from a model of decision-making under uncertainty using a real options methodology, developed by the International Energy Agency (IEA). The model represents investment decisions in power generation from the perspective of a private company. The investments are subject to uncertain future climate policy, which is treated as an external risk factor over which the company has no control. The aims of this paper are to (i) quantify these regulatory risks in order to improve understanding of how policy uncertainty may affect investment behaviour by private companies and (ii) illustrate the effectiveness of the real options approach as a policy analysis tool. The study analysed firms’ investment options of coal- and gas-fired power plants and carbon capture and storage (CCS) technologies. Policy uncertainty is represented as an exogenous event that creates uncertainty in the carbon price. Our findings indicate that climate policy uncertainty creates a risk premium for power generation investments. In the case of gas- and coal-fired power generation, the risk premium would lead to an increase in electricity prices of 5–10% in order to stimulate investment. In the case of CCS, the risk premium would increase the carbon price required to stimulate investment by 16–37% compared to a situation of perfect certainty. The option to retrofit CCS acts as a hedge against high future carbon prices, and could accelerate investment in coal plant. This paper concludes that to minimise investment risks in low carbon technologies, policy-makers should aim to provide some long-term regulatory certainty.