Emissions trading scheme design and investment behaviour in the Australian electricity generation sector


Event details

Date & time

Friday 07 May 2010


Seminar Room 1, Stanner Building (37), Lennox Crossing, ANU


Ross Lambie, PhD Candidate, POGO


Sandra Zec
6125 2188
Panel members: Prof Quentin Grafton, Dr Jack Pezzey and Dr Frank Jotzo
Discussant: Pamela Katic
Abstract: The objective of a greenhouse gas (GHG) emissions trading scheme (ETS) is to move the economy away from the production and consumption of goods and services that are emissions-intensive. A key determinant of the success of an ETS in achieving this objective is the response by firms in energy-intensive industries, such as electricity generation, in moving from high emissions production technologies to lower emissions technologies. Major policy analyses of an ETS simply assume that industries will adjust their investment behaviour relatively smoothly during this transition. Real options analyses of firm investment behaviour under an ETS provide compelling evidence that challenges the relevance of this assumption. These analyses are concerned with the phenomena of hysteresis in the adoption of low emissions technology that may arise when there are uncertainties in expected net returns and significant sunk costs. This paper uses real options modelling to examine how the design of a GHG ETS is likely to affect an Australian electricity generator’s decision to invest in a new lower emissions plant. Unlike previous analyses, which use stochastic dynamic programming, the real options modelling approach applies contingent claims analysis (CCA) to the problem of firm investment behaviour. CCA is considered superior in its treatment of risk compared to stochastic dynamic programming. This analysis focuses on uncertainties in the prices of electricity and emissions permits. Numerical analysis based on an emissions trading scheme closely resembling Australia’s proposed Carbon Pollution Reduction Scheme (CPRS) is presented along with sensitivity analysis reflecting changes in the scheme’s major design features. They suggest that technological hysteresis in electricity generation is likely to be a significant issue for an ETS with a design similar to that of the CPRS. A general conclusion reached concerning the CPRS is that its present design may be inadequate in providing the necessary incentives for generators to commit to investing in lower emissions plants.

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