The role of real options analysis in the design of a greenhouse gas emissions trading scheme

Analysing the effect of a greenhouse gas emissions trading scheme (ETS) on energy-intensive industries using a simple model of the long-run equilibrium fails to fully capture the design implications of a scheme. When we allow for imperfect market structures and uncertainty, it is more useful to focus on how an industry is affected by the scheme’s design in moving to its long-run equilibrium. A real options modelling approach that analyses how firms in these industries are likely to respond to an ETS through their investment behaviour is proposed as a more insightful method for public policy analysis

Understanding the effect of an emissions trading scheme on electricity generator investment and retirement behaviour: the proposed Carbon Pollution Reduction Scheme

The objective of a greenhouse gas (GHG) emissions trading scheme (ETS) is to reduce emissions by transitioning the economy away from the production and consumption of goods and services that are GHG intensive. A GHG ETS has been a public policy issue in Australia for over a decade. The latest policy initiative on an ETS is the proposed Carbon Pollution Reduction Scheme (CPRS). A substantial share of Australia’s total GHG reduction under the CPRS is expected to come from the electricity generation sector. This paper surveys the literature on investment behaviour under an ETS. It specifically focuses on the relationship between the design of an ETS and a generator’s decisions to invest in low emissions plant and retire high emissions plant. The proposed CPRS provides the context for presenting key findings along with the implications for the electricity generation sector’s transition to lower emissions plant. The literature shows that design features such as the method of allocating permits, the stringency of the emissions cap along with permit price uncertainty, provisions for banking, borrowing and internationally trading permits, and the credibility of emissions caps and policy uncertainty may all significantly impact on the investment and retirement behaviour of generators

Where is it Cheapest to Cut Carbon Emissions?

The relative cost of carbon emissions reductions across regions depends on whether we measure cost by marginal or total cost, private or economy-wide cost, and using market or purchasing power parity exchange rates. If all countries are on the same marginal carbon abatement cost curve then lower marginal costs of abatement are associated with higher energy intensities and higher total costs of abatement in achieving proportional cuts in emissions, equal emissions per capita, or common global carbon price targets. We test this conjecture using the results of the GTEM computable general equilibrium model as presented in the climate change economics review conducted by the Australian Treasury Department. Rankings of countries by costs do differ depending on whether marginal or total cost is used. But some regions, including OPEC and the former USSR, have high marginal costs and high emissions intensities and, therefore, high total costs and others like the EU relatively low marginal and total costs. Under a global emissions trading regime real economy-wide costs of abatement are higher in developing economies with currencies valued below purchasing power parity and large differences between private and economy-wide costs such as India contributing to the high GDP losses experienced in those countries