Using a price floor on carbon allowances to achieve emission reductions under uncertainty

Xinhua Zhang, C. Hueng and Robert J. Lemke

Economic Analysis and Policy, 2023, vol. 80, issue C, 1096-1110

Abstract: We build a real options investment model for carbon-allowance trading markets with a price-floor mechanism. A power plant faces a choice between undertaking an irreversible investment in carbon emission reduction or holding the option to invest later. The government encourages firms to invest immediately by guaranteeing a minimum value of the allowances. We use the Least Squares Monte Carlo method to find the value of the option and derive the firm’s threshold condition of whether to invest or to wait. The model allows us to compare the government’s costs of alternative policies for encouraging the investment. Using the newly established Chinese carbon emission trading scheme as an example to calibrate the model, simulations show that the expected cost to the government of the price-floor policy is lower compared with using a lump-sum subsidy or a preferential tax-rate policy designed to achieve the same level of reduction in emissions.

Keywords: Real options model; Price floor; Carbon emission reduction; Government subsidies (search for similar items in EconPapers)
JEL-codes: C61 D81 Q48 (search for similar items in EconPapers)
Date: 2023
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Persistent link: https://EconPapers.repec.org/RePEc:eee:ecanpo:v:80:y:2023:i:c:p:1096-1110

DOI: 10.1016/j.eap.2023.10.002

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