Firm investment behaviour under a carbon emissions pricing scheme : a real options analysis of investment in low emissions electricity generation technologies in Australia

Abstract

A general finding from the growing literature applying 'real options' theory to investment under carbon emission pricing schemes (CEPSs), is that the level of uncertainty in the expected price of carbon is a key factor in the extent to which a CEPS's design provides incentives for a firm to invest in lower carbon emissions technologies. Notwithstanding this finding, major public policy analyses of CEPSs have not utilised real options analysis to gain insights into the effect of a scheme's design on the likely investment behaviour of firms. This thesis argues that real options analysis should be included in the suite of tools for informing public policy on the design of a CEPS. This thesis contributes to understanding the features of a CEPS's design on the decision of a firm in an energy-intensive sector to invest in new lower-carbon emitting plant, when the investment decision lends itself to being characterised as a real option. In contrast to existing real options studies in this area, a simpler analytic approach is adopted based on a model by Cortazar et al. (1998). The approach captures output price and carbon price uncertainties and is solved using contingent claims analysis to find the critical price of output required to trigger the decision to invest. Two empirical applications examine in detail a representative electricity generator's decision to invest in a range of low carbon-emitting and non-carbon emitting electricity generation technologies. The analysis of both a hypothetical CEPS's design in general, and the post-2015 carbon emissions trading scheme under Australia's Clean Energy Future package (CEFETS) in particular, show that there are four effects on the threshold required by a generator to trigger investment in a technology that are attributable to the design of a scheme. In addition to the impact of volatility in the carbon price and its correlation with the output price (the volatility effect) highlighted in other real options studies, three additional investment threshold effects are found that may jointly impact on a firm's decision to invest in a particular technology depending on the design of a CEPS. The three effects consist of the cost effect, the negative cost effect and the subsidy effect. The cost effect arises from the level of the carbon price and impacts only carbon emitting technologies. The negative cost effect and subsidy effect arise from allocations of free carbon emissions rights under a CETS that directly subsidises either a plant's operating costs or investment cost, respectively, and may apply to all technologies. Show more