The effectiveness of carbon pricing: The role of diversification in a firm’s investment decision

Tine Compernolle, Peter Kort and Jacco J.J. Thijssen

Energy Economics, 2022, vol. 112, issue C

Abstract: It is often argued that compared to a carbon tax, a volatile carbon price under an emissions trading system poses a problem in the transition towards a low carbon economy. However, this paper shows that, when sufficiently positively correlated with the electricity price, carbon price uncertainty diminishes overall volatility because of a diversification effect. To get this result, we develop a dynamic real options model to analyze the impact of positively correlated price uncertainty on the timing of an investment decision. In contrast to static models, we show that even when the carbon price is initially the same under both policy instruments, the timing of the investment decision will typically be different. More importantly, we find that multiple correlated price uncertainties under an emissions trading system encourages investment more than less uncertainty under a carbon tax. Hence, to stimulate a low carbon (or discourage a carbon intensive) investment, an emissions trading system (carbon tax) is preferred. The policy reverts for higher levels of uncertainty and low correlations.

Keywords: Real options; Carbon tax; Emission trading system; Market price uncertainty; Correlation; Diversification; Carbon capture and storage (search for similar items in EconPapers)
JEL-codes: C61 G11 G17 L10 Q41 Q48 (search for similar items in EconPapers)
Date: 2022
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:eneeco:v:112:y:2022:i:c:s0140988322002742

DOI: 10.1016/j.eneco.2022.106115

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