Investment under market and climate policy uncertainty

Climate change is considered as one of the major systematic risks for global society in the 21st century. Yet, serious efforts to slow the accumulation of emissions are still in their primordial stage and policy makers fail to give proper long-term signals to emitters. These days, investors do not only face uncertainty from volatile prices in the traditional markets, but also from the less conceivable uncertainty of stricter climate change policy. This paper investigates the impact of learning about the commitment of government to a climate policy regime in a real options framework. Two types of uncertainty are distinguished: market-driven price volatility around a mean price and bifurcating price trajectories mimicking uncertainty about changing policy regimes. One of the findings is that the producer facing market uncertainty about CO2 prices invests into carbon-saving technology earlier than if the actual price path had been known on beforehand. This is not a typical real options outcome, but the result of optimizing under imperfect information, which leads to decisions that are different from the optimal strategies under full information. On the other hand, policy uncertainty induces the producer to wait and see whether the government will further commit to climate policy. This waiting is a real options effect. In other words, if learning about government commitment is more valuable than investing into mitigation technologies immediately, the option value exceeds the value of the technology and investment will be postponed. This might lead to supply shortages and limited diffusion of less carbon-intensive technology. (c) 2008 Elsevier Ltd. All rights reserved.