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

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  • Zhang, Xinhua
  • Hueng, C. James
  • Lemke, Robert J.

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.

Suggested Citation

  • Zhang, Xinhua & Hueng, C. James & Lemke, Robert J., 2023. "Using a price floor on carbon allowances to achieve emission reductions under uncertainty," Economic Analysis and Policy, Elsevier, vol. 80(C), pages 1096-1110.
    • Handle: RePEc:eee:ecanpo:v:80:y:2023:i:c:p:1096-1110
    DOI: 10.1016/j.eap.2023.10.002
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    References listed on IDEAS

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    More about this item

    Keywords

    Real options model; Price floor; Carbon emission reduction; Government subsidies;
    All these keywords.

    JEL classification:

    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • Q48 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Energy - - - Government Policy

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