Technology Choice and Capacity Portfolios Under Emissions Regulation

by David Drake, Paul R. Kleindorfer & Luk N. Van Wassenhove

Overview — What technologies should firms invest in when emissions are costly? With the European Union Emissions Trading Scheme in the EU, California's Assembly Bill 32, the Regional Greenhouse Gas Initiative in the northeastern US, and now Australia's Clean Energy Bill, more and more firms are having to ask themselves that question when planning their capacity portfolios. This paper uses formal theory to analyze firms' technology choice and capacity portfolios, both when emissions are taxed and when they are regulated under cap-and-trade. David Drake, Paul R. Kleindorfer, and Luk N. Van Wassenhove find that even when average emissions price is assumed to be equivalent to that under an emissions tax, firms are more profitable under cap-and-trade. The emissions price uncertainty under cap-and-trade that many argue will destroy value instead equips firms with a real option that increases value. In addition to comparing profits under emissions tax and cap-and-trade regimes, the authors identify a number of potential adverse outcomes that can arise as a consequence of emissions legislation that should be taken into consideration when formulating future climate policy. Key concepts include:

  • Decreasing a dirty technology's emissions intensity (emissions generated per unit of production) can result in an increase in the emissions intensity of a firm's long-term capacity portfolio.
  • Though a higher emissions tax rate is often assumed to spur greater investment in clean technology, the authors show that there are conditions under which a higher emissions tax rate leads to a decrease in clean technology investment.
  • The share of clean technology in a firm's long-term capacity portfolio can increase in the market price of the goods that they produce, which has implications for sectors made more vulnerable to competition as a consequence of emissions regulation.
  • Though many argue that an emissions tax would be more profitable for firms than a cap-and-trade regime due to the uncertainty in emissions price under cap-and-trade, the opposite is shown to be true. Even when average emissions price is assumed to be the same under both regimes, the uncertainty in emissions price under cap-and-trade equips firms with a real option that increases expected profits.

Author Abstract

We study the impact of emissions tax and emissions cap-and-trade regulation on a firm's long-run technology choice and capacity decisions. We study the problem through a two-stage, stochastic model where the firm chooses capacities in two technologies in stage one, demand uncertainty resolves between stages (as does emissions price uncertainty under cap-and-trade), and then the firm chooses production quantities. As such, we bridge the discrete choice capacity literature in operations management (OM) with the emissions-related sustainability literature in OM and economics. Among our results, we show that a firm's expected profits are greater under cap-and-trade than under an emissions tax due to the option value embedded in the firm's production decision, which contradicts popular arguments that the greater uncertainty under cap-and-trade will erode value. We also show that improvements to the emissions intensity of the "dirty" type can increase the emissions intensity of the firm's optimal capacity portfolio. Through a numerical experiment grounded in the cement industry, we find emissions to be less under cap-and-trade, with technology choice driving the vast majority of the difference.

Paper Information