The Logic of Carbon Risk from the Investor's Perspective: The Expected Carbon Payment

Abstract:     
The usual way to incorporate the notion of carbon risk (the financial risk associated with CO2 emissions under potential climate change policy) into investment decision-making is to include a cost of carbon in the budget analysis. Most existing literature uses the expected price of carbon as a proxy for this cost, where expected price is a weighted average of various scenarios, often comparing policy proposals and representing either the price of traded permits or level of carbon tax, depending on the type of policy. The literature focuses on the minimum price of carbon required to influence power plant investment decisions. In contrast, this paper introduces the idea of expected payment of carbon as a more accurate measure of carbon cost as it is perceived by industry practitioners. The expected payment of carbon is the expected price of carbon times the probability that this cost would actually be faced in the case of a particular investment. This concept helps explain both the surge of activity in 2005-2006 and the subsequent decline in interest in coal-fired power plant development. This paper relies on an extensive online survey of 600-800 energy professionals completed in 2006, as well as recent interviews with individual industry representatives.

Number of Pages in PDF File: 39

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