Assessing the effects of CO2 price caps on electricity investments--A real options analysis

This paper uses real options modeling to assess the impact of different climate change policy instruments on investment, profits and cumulative emissions in the electricity sector. Even though CO2 price caps or "safety valves" have been suggested as methods to limit uncertainty emanating from fluctuating prices of CO2 permits that would hurt the industry's profit and thereby also energy security, our analysis shows that price caps set at a too low level are detrimental to the adoption of e.g. modern biomass-fired capacity as a replacement for existing coal-fired power plants. We therefore conduct a series of experiments with different policy scenarios to analyze under which regime emissions are most effectively reduced. With respect to CO2 price uncertainty, it turns out that even for moderately rising CO2 prices, fluctuations frequently lead to investment into carbon capture and storage (CCS), while investment is often not triggered in the face of deterministic CO2 prices.