Irreversible Investment under Uncertainty in Electricity Generation: A Clay-Clay-Vintage Portfolio Approach with an Application to Climate Change Policy in the UK

UK climate change policy has long been concerned with the transition to a more sustainable energy mix. The degree of competition in electricity markets rises as these markets become more and more liberalized. In order to survive in such an increasingly competitive setting, electricity producers have to handle as efficiently as possible the uncertainties associated with the volatility of fuel prices, but also uncertainties regarding the technological evolution of electricity production (including the development of renewable technologies). Technological uncertainty in combination with high capital costs are likely to deter investors from adopting renewable technologies on a larger scale than they are doing right now, even though they have to accept a higher degree of fuel price risk by doing so. By carefully composing a portfolio of technologies with different (co-)variances in the respective prices and rates of technical progress, risk-averse producers can effectively hedge the uncertainties mentioned above. In order to model this type of investment behaviour, we use an extended version of the van Zon and Fuss (2005) clay-clay-vintage-portfolio model that starts from the notion that investment in electricity production equipment is irreversible. However, a physical capital portfolio - in contrast to a portfolio of financial assets - can only be adjusted at the margin. This implies that it becomes extremely important to look ahead, and act on not just expectations themselves, but also their reliability. Using the extended model, we implement several features of present UK policy in order to illustrate the principles involved. We find that the reduction of risk goes together with an increase in total costs. We also find that for increasing values of risk-aversion, investors would be willing to adopt nuclear energy at earlier dates than otherwise would have been the case. In addition to this, we find that the embodiment of technical change, in combination with the expectation of a future switch towards another technology, may actually reduce current investment in that technology (while temporarily increasing current investment in competing technologies). The latter enables rational but risk-averse investors to maximise their productivity gain by waiting for ongoing embodied technical change to take place until the moment they plan to make the switch and then investing more heavily in the newest vintages associated with that technology at the time of the switch.