A real option-based approach for CO2 price management Michael Loretz, University of Graz

1. A real option-based approach for CO2 price managementMichael Loretz, University of Graz November 25, 2010 RESOWI, SR 15.25 Michael Loretz

2. Motivation • Any meaningful climate change policy has to put a price on carbon dioxide emissions (Stern (2006)) • Price of zero leads to air pollution • The introduction of prices induces people to economize in the use of these resources • Impact on investment decisions Michael Loretz

3. Table of Contents • European Union Emissions Trading System • Introduction • Price Management - Theory • Price Management - Implementation • Investment Problem of the Firm • Methodological Approach Michael Loretz

4. Table of Contents • European Union Emissions Trading System • Introduction • Price Management - Theory • Price Management - Implementation • Investment Problem of the Firm • Methodological Approach Michael Loretz

5. Introduction • Single firm which has to comply with an emissions trading system • perfect competition • Firm faces investment decision between t and T • an investment enables the firm to switch to a“clean” technology (C) • without the investment the firm remains with the actual “dirty” technology (D) • Does the firm take care about the price of CO2-emissions when making an investment decision? Michael Loretz

6. Introduction • Firm is concerned with uncertain future prices • Input prices • e.g. for an electricity producing firm: oil, gas, coal, emissions • Output prices • e.g. electricity price • Using Real Option Theory to value the investment decision leads to an optimal investment time • Is a regulator able to influence the optimal investment timing? • To push technological advance? Michael Loretz

7. Price Management as Regulatory Option • Assumption • An emission trading system in form of a pure cap-and-trade system exists already • there are no price management mechanisms • Regulatory options • Price management • Price ceiling • Price floor • Price collar • Cap-and-Trade + Price Management = Hybrid System • Gruell& Taschini (2010), Murray et al. (2009), PwC(2009), Wood & Jotzo (2010) Michael Loretz

8. Table of Contents • European Union Emissions Trading System • Introduction • Price Management - Theory • Price Management - Implementation • Investment Problem of the Firm • Methodological Approach Michael Loretz

9. Price Management - Theory • price ceiling • maximum price Michael Loretz

10. Price Management - Theory • price floor • minimum price Michael Loretz

11. Price Management - Theory • price collar • fixed price range Michael Loretz

12. Table of Contents • European Union Emissions Trading System • Introduction • Price Management - Theory • Price Management - Implementation • Investment Problem of the Firm • Methodological Approach Michael Loretz

13. Price Management - Implementation • price ceiling (safety valve) • policy regulator sells an (un)limited amount of permits • carbon tax if price ceiling is reached • like an American call option for compliance units • allowance reserve • relaxing the maximum amount of offsets valid for compliance • regulator sells call options to firms willing to buy protection Michael Loretz

14. Price Management - Implementation • price floor • policy regulator purchases an (un)limited amount of permits • similar to a subsidy • like an American put option for compliance units • reserve price at auctions • with subsequent purchasing of the policy regulator • regulator sells put options to firms willing to buy protection Michael Loretz

15. Table of Contents • European Union Emissions Trading System • Introduction • Price Management - Theory • Price Management - Implementation • Investment Problem of the Firm • Methodological Approach Michael Loretz

16. Investment Problem of the Firm • Firm faces investment decision between t and T • an investment enables the firm to switch to a“clean” technology (C) • without the investment the firm remains with the actual “dirty” technology (D) Michael Loretz

17. Cash-Flow of the Technologies • cash-flows of the different periods represent the respective profits • profit = revenue - variable costs - fixed costs Michael Loretz

18. Rationale for Regulatory Intervention • Target is a change of optimal investment timing, such that • is the optimal investment timing with regulatory policy • e.g. cap-and-trade with price floor/ceiling/collar • is the optimal investment timing without regulatory policy • i.e. pure cap-and-trade Michael Loretz

19. Effect of regulatory policy on investment timing • Optimal investment time occurs earlier • i.e. technological advance is pushed by regulator InFra_CO2

20. Investment Timing and American Options • The question of optimal investment timing is closely connected to American Option characteristics • there is no closed-form solution available • numerical solution procedures have to be adapted to solve the problem at hand • American option characteristics demand dynamic programming techniques Michael Loretz

21. Table of Contents • European Union Emissions Trading System • Introduction • Price Management - Theory • Price Management - Implementation • Investment Problem of the Firm • Methodological Approach Michael Loretz

22. Methodological Approach • Stochastic input/output price processes • Simulation of projects cash flows • using stochastic input/output prices • Dynamic Programming to solve for optimal investment timing • close similarity to characteristics of an American option • optimal timing of investment decision leads to maximum net present value • Central is the calculation of the expected conditional value Michael Loretz

23. Methodological Approach • Least squares Monte Carlo (LSM) approach (Longstaff & Schwartz (2001)) • Monte Carlo simulation techniques • Backward dynamic programming techniques • Conditional expectation is estimated from cross-sectional information • Delivers the value of the real option and the optimal investment timing Michael Loretz

24. Thank you! • Questions & Remarks Michael Loretz

25. Literature • Copeland, T., & Antikarov, V. (2003). Real Options - A Practitioner's Guide. Thomson - Texere. • Dixit, A. K., & Pindyck, R. S. (1994). Investment under Uncertainty. Princeton University Press, Princeton, New Jersey. • Longstaff, F., & Schwartz, E. (2001). Valuing American options by simulation: a simple least-squares approach. Review of Financial Studies, 14(1), 113-147. Michael Loretz

26. Literature • Cortazar, G., Gravet, M., & Urzua, J. (2008). The valuationofmultidimensional American real optionsusingthe LSM simulationmethod. Computers & Operations Research, 35(1), 113-129. • Fuss, S., Szolgayová, J., Khabarov, N., & Obersteiner, M. (2010). Renewablesandclimatechangemitigation: Irreversible energyinvestmentunderuncertaintyandportfolioeffects. EnergyPolicy, In Press, CorrectedProof. • Yang, M., Blyth, W., Bradley, R., Bunn, D., Clarke, C., & Wilson, T. (2008). Evaluatingthe power investmentoptionswithuncertainty in climatepolicy. Energy Economics, 30(4), 1933-1950. Michael Loretz

27. Literature • Gruell, G., & Taschini, L. (2010). Cap-and-trade properties under different hybrid scheme designs. Journal of Environmental Economics and Management, In Press, Corrected Proof, -. • Murray, B. C., Newell, R. G., & Pizer, W. A. (2009). Balancing Cost and Emissions Certainty: An Allowance Reserve for Cap-and-Trade. Review of Environmental Economics and Policy, 3(1), 84-103. • PwC. (2009). Carbon Taxes vs Carbon Trading - Pros, cons and the case for a hybrid approach. Report prepared for the IETA, 1-30. • Wood, P., & Jotzo, F. (2010). Price Floors for Emissions Trading. FEEM Working Paper No. 382.2010. Michael Loretz