The Threat of Carbon Regulation & Business Hedging Strategy

This project has built on previous collaboration between the involved participants concerning real options modelling and applications to energy investments and the implementation of REDD (Reducing Emissions from Deforestation and forest Degradation). This time the focus was on the role of technical change and the options that investment into R&D might open up. The main objective of the project was to offer a new perspective on business decision-making processes in the energy sector facing uncertainty about future regulation of emitting CO2: in this case R&D in more climate-friendly technology might offer additional flexibility to businesses, which standard investment theory fails to value explicitly. Furthermore, adding an option on REDD to this framework has shown that there can be important synergies between different risk-hedging strategies. In fact, a set of different options serving to enhance flexibility in the face of uncertainty can be interpreted as a portfolio of strategies, where the value of one option will differ in the presence of another one. Finally, there are two types of uncertainty, which have been addressed in this project: on the one hand, there is uncertainty about the future stringency of climate policy (here modelled through different CO2 price paths consistent with different stabilization scenarios taken from IIASA's GGI Scenario Database). On the other hand, there is uncertainty about the speed, at which technological progress will lead to the improvement of carbon-saving technology. Technical change in this case is driven by investment in R&D, which in turn responds to beliefs about future price signals.