Irreversible Abatement Investment Under Cost Uncertainties: Tradable Emission Permits and Emissions Charges

Abstract

A major concern with TEPs is that stochastic permit prices may reduce firm incentive to invest in abatement capital or technologies relative to other policies such as a fixed emissions charge. However, under efficient permit trading, the price uncertainty is caused by abatement cost uncertainties which affect investment under both permit and charge policies. We develop a rational expectations general equilibrium model of permit trading and irreversible abatement investment to show how cost uncertainty affects investment. Differences between the effects of uncertainties under the two policies can be decomposed into a general equilibrium effect and a price-vs-quantity effect. After controlling for the assumption that the random variables enter the abatement cost function linearly, we find that uncertainties reduce both effects. In particular, firms' investment incentive decreases in cost uncertainties, but more so under emissions charges than under permits. Therefore, tradable permits in fact help maintain firms' investment incentive under uncertainty.

JEL Classification: Q20