Investors’ Reaction to the Government Credibility Problem: A Real Option Analysis of Emission Permit Policy Risk

44 Pages Posted: 26 Jan 2012 Last revised: 3 Sep 2015

See all articles by Sang Baum Kang

Sang Baum Kang

Illinois Institute of Technology - Stuart School of Business

Pascal Letourneau

University of Wisconsin - Whitewater

Date Written: September 2, 2015

Abstract

In relation to creating a CO2 emission permit market, there are two types of climate change policy risks: 1) It is uncertain whether and when a cap-and-trade system will be implemented; and 2) once a policy is in place, there may be government credibility issues. This paper examines the effect of these policy risks on real option decisions of electric power plant investment. To model both an investment decision and generation flexibility, this study evaluates an exotic compound American option on multiple strips of European spread options through the implementation of least squares Monte-Carlo simulation. Government credibility risk leads to more investment in “less green” resources and induces additional cash flow variation, which increases the average time to investment (value of waiting). However, in an extreme case, government credibility can actually hasten investment because the risk may be more favorable to electric power companies. Furthermore, if emission trading is planned to be implemented in the future (e.g., 2020), and the market believes that the probability of successful implementation is low, firms will build a “less green” plant early to benefit from the period before the green rule is applied.

Keywords: government credibility, climate change policy, emission trading, real option, compound option, least squares Monte-Carlo simulation

JEL Classification: D81, G13, Q50

Suggested Citation

Kang, Sang Baum and Letourneau, Pascal, Investors’ Reaction to the Government Credibility Problem: A Real Option Analysis of Emission Permit Policy Risk (September 2, 2015). Available at SSRN: https://ssrn.com/abstract=1552626 or http://dx.doi.org/10.2139/ssrn.1552626

Sang Baum Kang (Contact Author)

Illinois Institute of Technology - Stuart School of Business ( email )

565 W Adams St
Room 448
Chicago, IL
United States
312-848-2659 (Phone)

Pascal Letourneau

University of Wisconsin - Whitewater ( email )

Whitewater, WI 53190
United States

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