EPRG WORKING PAPER. Tim Laing and Michael Grubb. EPRG Working Paper 1004 Cambridge Working Paper in Economics 1012

Transcription

1 he Impc of Insrumen Choice on Invesmen in emen echnologies: Cse Sudy of x versus rde Incenives for CCS nd Biomss for Elecriciy ERG Woring per 004 Cmridge Woring per in Economics 0 im Ling nd Michel Gru ERG WORKING ER src Keywords here hs een wide discussion on he differen properies eween cron xes, cp-nd-rde schemes nd hyrid insrumens such s cp-nd-rde schemes wih price floors nd ceilings. here hs een less discussion on he incenives o invesmen h ech of hese insrumens my provide. We uild hree-period model o invesige he incenives offered o lrge firm wih diversified emen opions from such insrumens when fcing choice eween invesing in lowcron echnologies wih poenil lerning enefis. We prmeerise our model for sysem similr o he EUES nd for wo smple echnologies, iomss for elecriciy nd col wih cron cpure nd sorge. or oh echnologies we find h cp-nd-rde schemes genere greer men reurns o such n invesmen hn xes, u wih wider disriuion. We find h inroducing price floors increse such men reurns while reducing he disriuion, while ceilings furher reduce he disriuion, u lso he men nd hus he overll incenives hey offer will depend on he ris preference of he firm nd scle of invesmen in relion o overll complince coss. Conc jl40@cm.c.u ulicion erury 00 inncil Suppor ESRC, SEC Cron Mres, Invesmen, Cp-nd-rde, CCS, Biomss

2 ERG WORKING ER

3 he Impc of Insrumen Choice on Invesmen in New emen echnologies: Cse Sudy of x versus rde Incenives for CCS nd Biomss for Elecriciy im Ling Elecriciy olicy Reserch Group, Universiy of Cmridge Michel Gru Elecriciy olicy Reserch Group, Universiy of Cmridge. Inroducion he greenhouse gses reducions h will e necessry o limi he dmges from clime chnge re liely o require widespred innovion in, nd deploymen of, new echnologies. his will require oh lrge ddiionl invesmens, nd lso shif from invesmen in cron polluing echnologies. lcing price on cron emissions, eiher hrough x or hrough cp-ndrde schemes helps o incenivise such echnologies. his is especilly crucil for oh end-of-he-pipe echnologies such s Cron Cpure nd Sequesrion CCS for which he only moivion o implemen is o reduce cron emissions nd lso echnologies such s iomss for power which hve poenilly wider enefis such s energy securiy, u for which cron policies cn provide significn incenives noneheless. roviding cler nd sufficien incenives for oh ypes of echnologies is one of he muliple ims of cron miigion policies. he levels of invesmen h insrumens o ddress cron emen drive my e crucil in meeing he long-erm chllenge of miigion. CCS is prediced o ply mjor role in oh he elecriciy nd indusril secor in he decdes o come for exmple see nndrjh e l. 009, ye so fr here hs een limied prive secor invesmen. Biomss energy uilision is echnology h is rcive for is cron neurliy nd cn poenilly mee wide vriey of energy needs including elecriciy supply. Dous remin over he siliy of supply chins, nd developmen in his re from lerning-y-doing is crucil for wider deploymen of he echnology. Elecriciy olicy Reserch Group, Universiy of Cmridge, Corresponding uhor: culy of Economics, usin Roinson Building, Sidgwic venue, Cmridge CB 9DD jl40@cm.c.u

4 he reurns h n invesmen in such echnologies my yield o invesors depend on he exc nure of he cron policy implemened y governmens. Our wor compres he differing firm-level reurns o invesmen h hese differen insrumens yield. Under ceriny nd complee informion, here is equivlence eween xion nd quniy conrols for conrolling polluion. or mny siuions including clime chnge, however, here is neiher ceriny nor complee informion. Uncerinies persis over oh he coss of conrolling emissions nd he dmges emning from hese emissions, s well s he ssocied nure of, nd he response o, fuure policies; nd ll of hese compounds he symmeric informion h exiss eween firms nd regulors. n exmple of he rnge of unceriny over dmges or he socil cos of cron cn e seen in igure. Esimes for 050, even for his specific model vry y fcor of more hn weny. he uncerinies cn e grouped ino wo sic res. he firs concerns he liely cos of cron h firms will fce. Uncerinies over he impc of Greenhouse Gs GHG emissions on he clime compound wih geogrphicl nd economic fcors o cree lrge uncerinies over he level of dmges, resuling from cerin level of GHG emissions. In ddiion here is mjor policy unceriny over oh he choice nd level of insrumens pu in plce o ddress cron emen nd heir economic implicions. I is hrough his chnnel of policy h such uncerinies mnifes hemselves o firms. he second re of unceriny reles o h rising round possile miigion echnologies. Unceriny nd symmeric informion exiss over mny fces of such echnologies. s mny of he echnologies h re liely o e required re new nd relively sprsely deployed here re lrge uncerinies over he pce nd scle of fesile deploymen of hese echnologies, long wih wide rnges of esimes over oh cpil nd opering coss. hese uncerinies re liely o e lrger for regulors hn for firms due o symmeric informion eween he pries.

5 igure : Socil cos of cron over ime, Hope nd Newery 008 Our im is o invesige he impc h he choice of insrumens hs on firmlevel incenives o inves in new echnology in world wih uncerinies such s hose descried ove. I is well eslished h cron pricing cn ply ey role in creing incenives see for exmple Sern 006, nd erlier wor y igou 90 nd Cose 960. However here is long snding dee ou he relive meris of doing so hrough direc x, or hrough sysem h cps quniies nd eslishes mre in emission llownces cp-nd-rde. he dee hs een refleced in policy developmen. In 990 he US eslished cp-nd-rde scheme for reguling SO emissions, nd during he susequen decde he EU emped o inroduce cron x for reguling greenhouse gs emissions. he EU's cron x evenully filed fer widespred opposiion from indusry nd severl memer ses nderson e l. 996, Bergesen e l. 994 nd round 000 EU effors swiched o considering cp-nd-rde scheme for cron dioxide, which cme ino force in 005. However, voliliy in he price coupled wih surplus llocions - nd opposiion in he US o plns for greenhouse gs cp-nd-rde scheme here - hve renewed some poliicl dee ou he choice. he experience poins o poenil poliicl economy dvnges o cp-nd-rde pproch, u his pper focuses upon economic incenives. We uild on exising srnds of wor h model he choice eween xes nd quniy consrins when viewed from sociel perspecive nd wor h compres he impc h he choice of insrumens hs on invesmen incenives in world wihou unceriny. We uild simple, sylised, muli-period model o exmine he reurns h firm cn oin from invesing in new emen echnology. We explore is ehviour nd implicions using prmeers for wo echnologies, Biomss for elecriciy nd CCS, nd for rding sysem similr o he EU s Emission rding Scheme EUES o gin greer insighs relevn o he clime chnge prolem.

6 Our model generes disriuions of he reurns over nd ove invesmen for oh echnologies gins reference invesmen. We oin disriuions for xes under differen mehods of formion, cp-nd-rde schemes nd cpnd-rde schemes wih price floors nd ceilings. We find h he disriuion of reurns vry eween hese insrumens, wih cp-nd-rde schemes genering greer men reurns hn xes in wo ou of hree cses, u wih much wider disriuion of reurns. he inroducion of floors cn increse verge reurns nd reduce he disriuion, while ceilings furher reduce he disriuion u he cos of verge reurns. Our wor dds o he lierure in numer of res, y dding unceriny ino he discussion of invesmen incenives from differen insrumens for polluion, y focusing previous wor compring insrumens under unceriny on he incenives hey offer o firms, y exending wor ino muli-period world wih progrmme of invesmen nd y pplying such wor o poenilly imporn echnologies. In Secion we discuss some of he exising lierure in his re. Secion oulines he heoreicl model h we consruc. In Secion 4 we descrie he d we use for clirion of he model. Secion 5 oulines our resuls from he clired model. We discuss implicions for policy in Secion 6 nd conclude in Secion 7.. Lierure Invesmen under unceriny hs een sudied exensively in he lierure Dixi nd indyc 994, Celero 99. Ber nd du-bonnh 008 pplied his lierure o clime chnge y nlysing how he level of socilly opiml R&D invesmen chnges wih he ris profile of he R&D progrm nd unceriny ou clime dmges. hey exmine wo ypes of echnicl chnge, differenied y heir effec on he emen cos funcion: one which hey erm lernive R&D, which shifs he emen cos funcion down y fixed percenge; nd he second which hey erm convenionl echnology, which reduces he emissions-oupu rio nd reduces everywhere wely he cos of emen, whils leving he full cos of emen unchnged. he ler of hese chnges hs he ffec of reducing he mrginl cos in some res of he curve, whils incresing i higher levels of emen, implying pivo of he ffine mrginl emen curve. In he firs cse of echnicl chnge hey find h opiml invesmen is higher in risy R&D hn in non-risy, while in he ler he level of invesmen in R&D depends more on he level of dmges from clime chnge hn he ris profile of he R&D. numer of uhors hve underen wor which rn differen policies such s xes, ucioned nd free permis nd performnce sndrds for polluion emen ccording o he firm level incenives o undere invesmen in emen echnologies h hey yield Millimn nd rice 986, Jung, Kruill nd Boyd 996, Monero 000, Reque nd Unold 00. his group of wor yields differen rnings of insrumens depending on ssumpions over he ype of firm or indusry undering invesmen, he sge in he innovion process 4

7 nd he mre srucure of oupu nd permi mres. One common feure mong his lierure is he sence of unceriny in is nlysis. his omission of unceriny is mjor limiing fcor in pplying he lierure s conclusions o prolems such s clime chnge. second srnd of lierure hs compred he properies of insrumens such s xes nd quniy consrins, oh rded nd non-rded in he presence of unceriny. his lierure uses oh nlyicl nd prmeerised models h exmine he differing properies of insrumens for polluion conrol from roder perspecive, focusing on overll sociel enefis rher hn firm-level incenives o invesmen. Weizmn 974 invesiged he choice eween xes nd quniies in he presence of unceriny nd found h he comprive dvnge of prices over quniies depends on he relive slopes of he mrginl cos nd enefi curves. Weizmn s wor is no clime-specific, lhough i hs een used o rech conclusions regrding he issue. he socil cos of cron, he mrginl enefi of emen, cn e ssumed o hve smller slope les in erms of nerime emen hn mrginl emen coss, ssuming clime chnge o e fundmenlly soc prolem. Dmges re lined o ggrege GHG concenrions, hus one onne of GHG emied hs similr coss s ny oher, implying relively fl socil cos of cron curve. emen coss, on he oher hnd, rise shrply s emen increses, s here re numer of relively chep miigion opporuniies ville energy efficiency for exmple, u once hese opporuniies hve een uilised coss rise shrply. s rgued y severl susequen uhors, Weizmn s nlysis would, from his perspecive, fvour he use of cron xes over quniy consrins. igure shows n exmple of he Weizmn nlysis where oh he emen coss nd he socil coss re sujec o cerin degree of unceriny. In he digrm xes nd quniy consrins re deermined s per he expeced levels of mrginl emen coss MC E nd socil coss of cron wih xes E, nd quniy consrins E. If however mrginl emen coss re cully higher hn expeced MC Rel, where Rel represens he efficien level of emen in such cse, he efficiency loss from xes is fr smller hn h from permi schemes, hus fvouring he use of xes. 5

8 MC REL Socil Cos of Cron, Mrginl emen coss ermi efficiency Loss MC E Mrginl emen Coss E, E x efficiency loss Socil Coss of Cron Rel E GHG emen igure : Sylised represenion of he insrumen choice prolem sylised Source: Diez 006 Socil Cos of Cron, Mrginl emen Coss Ineri/ Loc-In Mrginl emen Coss Innovion Socil Cos of Cron GHG emen igure : Represenion of he clime prolem reflecing furher deils In reliy he clime prolem is more complex hn he sylised represenion in igure. igure illusres more ccure porryl of he clime prolem. he scle of unceriny over dmges is vs, even lrger hn h porryed here nd cerinly greer hn h surrounding mrginl emen coss. Mrginl emen coss curves re lso highly convex, hus heir slope depends on he scle of emen eing considered. he soc nure of clime chnge, long wih issues of ineri, nd long-erm invesmens h re 6

9 lrge pr of he energy sysem, mens h he prolem mus e seen in dynmic conex; such feures, long wih he impc of innovion cn oh shif nd chnge he slope of he mrginl emen curve. ing ino ccoun hese elemens mens h he issue of he opiml choice of insrumen is sill unresolved. os-weizmn here hs een numer of ppers exending his wor in some of hese highlighed res nd exending his nlysis o he clime prolem. Svins 996 exended he wor y exmining he cse when cos nd enefi uncerinies re correled nd found h posiive correlions end o fvour quniy insrumens while negive correlions fvour price insrumens. or plusile vlues of prmeers hey find h quniy insrumens my e fvoured over price insrumens. Hoel nd Krp 00 compre xes nd quos when regulors hve symmeric info ou he slope of firms' emen coss wih dmges rising from soc pollun. Using n inegred clime-economy model wihou endogenous echnology chnge izer 00 found h xes re more efficien hn permis y fcor of five o one, hough hyrid policy llows he sme efficiency while minining he flexiiliy o disriue he rens. Newell nd izer 00 exend Weizmn s nlysis o soc exernliies. s in Weizmn hey find h relive slopes re he ey deerminns of he efficiency of he insrumens, however hey find h furher elemens re lso imporn including correlion of cos shocs over ime, discouning, soc decy nd he re of enefis growh. hillier 008 uses n emen Coss emperure Chnges CC model o conduc quniive ssessmen of price cps nd floors, concluding h hyrid insrumens my e eer hn ny single insrumen. hey clire he model using esimes for greenhouse gses nd find h xes produce greer overll reurns hn quos when here is muliplicive unceriny. Weer nd Neuhoff 008 exmine he effecs of firm-level innovion in cron-emen echnologies on opiml cp-nd-rde schemes wih nd wihou price conrols hrough n nlyicl model. hey find h n increse in innovion effeciveness lowers opiml emissions cps nd relxes price conrols. Innovion mes he opiml insrumen more similr o cp; i widens he spred of he opiml floor nd ceiling. lhough he re of suile insrumen choice for miigion of GHG emissions hs een widely sudied, here is lile wor in he specific re of he firm-level invesmen incenives in world wih unceriny. Our wor sis eween he srnd of lierure h focuses on invesmen incenives o firms of polluion emen insrumens, nd he srnd focusing on he overll choice of insrumens for clime chnge. We uild on he lierure exmining incenives y offering n lernive modelling of he impc of new echnology on he emen curve, uilding in uncerinies nd prmeerising for relevn echnologies. We drw lessons from he lierure exmining he overll efficiency of cp-nd-rde schemes versus x regimes under unceriny, 7

10 prmeerised for clime chnge nd pply hem o focused nlysis on he invesmen-incenives offered o firm.. Model We consruc hree-period model o exmine he effecs of xion regime nd cp-nd-rde scheme on he incenives o inves in new cron-ing echnology in he presence of uncerinies. We consruc heoreicl frmewor nd prmeerise he model o wo exmple echnologies, iomss for elecriciy nd CCS, running he model under Mone-Crlo simulions. Our model generes reurns o n invesmen in he echnology over hree period ime-frme we use o represen ime period, {,, } in comprison o reference invesmen. We compre he disriuions of hese reurns under he differen insrumens. Our focus is on how he policy environmen ffecs he incenives for ny individul firm o inves in risy low cron echnology. We llow for he possiiliy h he firm nd he echnology my e non-mrginl o he sysem, i.e. h he firms choice my hve non-negligile implicions for he overll sysem s emissions nd hus implicions for cron prices. Specificlly we nlyse he incenives on specific energy supplying firm,, who cn undere n invesmen in new echnology,. he firm operes under clime policy, eiher x or cp nd rde scheme. he reminder of firms opering under he clime policy re represened s single sysem, S, nd re ssumed o no inves in he new echnology. We me numer of ssumpions regrding he echnology, he mre chrcerisics nd he emen opions open o he firm. echnologies involved in ing emissions hve very differen properies. hese properies ffec how he inroducion of such echnologies mends he mrginl emen curve ville o firms. We ssume h he specific echnology h we model hs high iniil coss prior o invesmen in comprison o he price of cron produced y he cron policy. hus in order for such echnologies o e deployed iniilly, he ime of he iniil invesmen here mus e some expecions of fuure profiiliy infr-mrginl rens for he firm o me he iniil invesmen. fer he iniil invesmen, he sun cos no longer ffecs operionl or pricing choices. Our im is o genere he moun of reurns firm cn ern over nd ove his sun cos for he differen insrumens for given ssumpions over echnology nd emission unceriny. In he ineres of simpliciy we ssume h he firm fces he choice eween wo invesmens oh yielding he sme oupu which cn e sold in he sme mre, one of which is he new echnology nd one of which is ermed reference opion, R 4. Essenilly we ssume he firm hs choice of invesing in We ssume h he firm is unle o pss on he cron coss o he consumers of is produc. 4 his cn e hough of s sndrd high-cron echnology. 8

11 wo plns which produce he sme moun of produc. his llows us o disregrd he effec of he echnology on oher coss nd he wider produc mre nd focus solely on emen nd he impc of he cron policy. he wo invesmens re ssumed o hve differen emissions levels nd cpil nd opering coss. he new echnology is ssumed o hve reduced emission levels nd higher cpil nd opering coss in comprison o he reference opion, nd hus hs posiive cos of emen. Our model uilises defined mrginl emen curve for oh he firm,, nd he sysem,. his llows us o deermine he price of cron h is necessry S o produce level of emen s defined y n ssumed cp. We ssume he firm hs wide rnge of emen opporuniies open o i which my resul from diversified pln porfolio nd llows us o ssume coninuous emen curve for he firm, rher hn discree series of opions. urher we ssume h here is defined, monoonic y definiion nd herefore inverile 5 emen funcion for oh he firm nd he sysem h deermines he moun of emen underen s funcion of he price of cron fced, wheher hrough cron x,, or from purchsing llownces in mre, wih price. urhermore we ssume h hese funcions re sle over ll periods in our model. 6 We ssume his siliy in order o simplify our nlysis nd define single emen curve for our model h remins for ll periods. he ssumpion of siliy effecively removes one elemen of unceriny from our model, llowing us o focus on unceriny regrding emission forecss nd he individul echnology. he new echnology requires n ddiionl level of invesmen I over he reference opion, wih n invesmen in period resuling in level of expeced emen,, in he susequen period, implying funcion I = I. his iniil invesmen in he echnology effecively crees ddiionl emen opporuniies which re depiced y new liner secion in he emen curve n emen cos of,, up o volume of nd shifs he emen curve ps his poin see igure. he emen cos includes oh he opering cos of he echnology nd ddiionl inpus h my e required in order o produce he sme oupu of he good defined in erms of cos per on of CO ed. 5 his is ssumed in order for prices of permis nd mouns of emen o e deermined in he model. 6 his is srong ssumpion. Wor y Morris, lsey nd Reilly 008 nd Klepper nd eerson 006 hve discussed he siliy of he emen curve wih shifing glol energy prices nd policies in oher regions. We ssume siliy s i llows us o hve one emen curve hroughou he model nd we cn ignore ny endogeniy eween fcors in our model nd he emen curve. 9

12 Cos $/on CO emen cos curve wihou new echnology Cron rice, or Ren for cpil cos recovery emen cos curve fer iniil invesmen in New echnology Opering coss of new echnology, emen on CO moun of emen from New echnology, igure : Effec of invesmen in new echnology on he emen cos curve he governmen ses eiher he cron x or he level of llownces h i ucions 7 Cp, E. here is single mre price h rises from hese ucions,, which firms cn purchse ll he llownces i requires. irms re required o purchse llownces for ll of heir emissions in ny single period nd here is no ning or orrowing of llownces nd no exernl purchses of credis from oher mechnisms. We define he vrile Cp s he cul level of emen required in he sysem s whole. Cp is hus he difference eween he level of emissions firms would produce wihou ny clime policy, E j j {, S}, nd he volume of llownces offered for ucion: Cp = E E S E Cp We deermine prices in he cron mre using he inersecion of he level of overll emen required, Cp, nd he overll emen funcion of oh he W firm nd he res of he sysem,. W S = We use he following funcion o deermine he price emning from he mre: W W Cp for Cp W W = = for Cp Cp = W Cp < W for < Cp 7 We ssume here is no iniil free llocion of permis o firms. 0

13 W where Cp is he inverse of W defined he level of emen Cp. his llows he price o e deermined for ll cses, including when he echnology is he price seer. We model hree periods in order o model progrmme of invesmen, where firms commi o undering n iniil invesmen followed y second lrger invesmen in he susequen period. In he reference opion he firm underes invesmen in he reference pln in eriod, nd hen is le o uilise he pln in eriods nd. In he scenrio where he firm underes invesmen in he new echnology he following occurs: In eriod, he firm underes invesmen in he new echnology. his invesmen could e in numer of differen forms. or exmple, i could e h he firm underes consrucion of new col pln fied wih CCS. he pln does no ecome operionl unil eriod nd hus does no ffec emissions or oupu revenues in eriod. In eriod, he firm cn opere he new echnology h hey hve invesed in wih corresponding impc on oh he firm nd overll emen funcion. s per he progrmme of invesmen here is furher invesmen in eriod which resuls in furher deploymen of he echnology in eriod. his llows us o model siuion where firm uilds one pilo pln iniilly, nd hen undere lrger deploymen, o furher heir experience nd nowledge of he echnology. lhough hese invesmens could e hough of s one single invesmen hrough sged pymens we choose o model i s wo sepre invesmens o more closely represen he rel-world decision-ming nd lso o leve scope for fuure exension o he model where he second invesmen is coningen on vrious resuls from he firs. his sge we ssume h he second invesmen occurs uncondiionl on he oucome of he iniil invesmen. We ssume h he level of invesmen in his eriod is wice he scle of h which occurred in eriod nd he resuling level of emen in eriod is doule h chieved in eriod. We furher ssume lerning curve in invesmen coss reled o he cul level of emen in eriod : I = αi, where 0<α< In eriod he firm is le o opere oh he echnology from he relision from invesmen in eriod nd lso he relision of he echnology from he susequen invesmen in eriod. he hird period cn e concepully hough of s n exension of he second.

14 Our curren model does no coun enefis eyond eriod in order o simplify he nlysis. here re, however, numer of possile resons s o why he firm my no vlue enefis eyond his horizon in ming heir originl commimen: firms my e expecing mnde o implemen he echnology; hey my discoun hevily due o scepicism ou susined poliicl commimen o he clime policy eyond his poin; or hey my e unle o hrness heir comprive dvnge over he echnology due o, for exmple, ll firms hving free ccess o he echnology his poin. his does men, however, h our model ends o underesime he poenil sregic reurns o he invesmen h my resul from eing n erly developer nd invesor in he echnology. s discussed ove we exmine coss solely in erms of emen coss nd complince wih he cron policy s in our model he firms choice of invesmen does no chnge heir overll oupu or he mre h hey cn sell i in. In eriod, coss o he firm under oh scenrios re funcion of he level of emen underen, he level of emissions from he firm efore emen nd he invesmen coss in he new echnology. 8 In he reference scenrio he ls erm of his equion is zero s here is no ddiionl invesmen. C = E. d I 0 In eriod in he new echnology scenrio, coss re funcion of level of emen, he level of emissions from he firm efore emen, he relised emen from he new echnology nd he opering coss of he echnology. Coss in period re similr u wihou he ddiionl invesmen. C C = E = E d d.. I We define he reurns from invesmen s he presen vlue of reduced coss for he firm in comprison o he reference scenrio. In order o clcule his we compre he coss h he firm would fce, wih nd wihou he invesmen in he new echnology. he ol reurn under cp-nd-rde scheme in one ime period is: Reurn R =.. E R d I 8 We use he cse of he cp-nd-rde scheme s we se ou our model. Unless oherwise sed he formuls re he sme for he x scheme, wih replced y.

15 where {,} nd invesmen in he echnology. R is he level of he cron price in he reference opion wih no Overll reurns re he discouned sums of hese Reurns over ll ime periods. 9 We uild hree min sources of unceriny ino our model: unceriny over he emissions levels wihou emen for oh he firm nd he res of he sysem; unceriny over he opering cos of he new echnology; nd unceriny over he level of emen from he iniil invesmen. In order o model he unceriny over emissions levels, we ssume h here is n emission shoc which ffecs oh he firm nd he sysem in eriods nd. his shoc cn e hough of s chnge in generl economic condiions which ffecs he oupu of firms, nd herefore emissions. One complexiy fcing oh firm nd regulors is h such emission shocs could occur ny ime, nd my or my no persis. o cpure his we ssume h here cn e persisence in he shoc cross periods. In order o model his we use wo correled norml disriuions. X ~ N0, his is he shoc h occurs in eriod σ ~ N0, σ X, X X his is he shoc h occurs in eriod Cov = δ he covrince of he shocs h occur in eriods nd Emissions of he firm in eriod re equl o he expeced level plus rndom drw from X while emissions in eriod re equl o he expeced level plus rndom drw from X. he sme drws, scled up, re used o clcule emissions for he sysem. 0 he unceriny in emissions levels efore emen implies h, lhough he governmen cn define he level of emissions llowed wih ceriny, he level of emen h his implies is uncerin. We model echnology unceriny y ming rndom drw from norml disriuion ~ N E, σ where E is he expeced opering cos of he new echnology. In order o model unceriny over he oucome from he iniil level of invesmen, we ssume h he moun of emen h he firm cn uilise in eriod resuling from he firm s iniil invesmen in eriod is uncerin. he cul level of emen ville is drwn from uniform disriuion ~ U α, β, where α is he lower ound nd β he upper ound of emen relised. 9 hese formule wor in he simple resriced cse. In order o clcule reurns for ll cses we exend hese formule o exmine cses where he new echnology is mrginl, or where ll emissions re ed. See nnex for full equions h opere in ll cses. 0 his implies perfec correlion eween he shocs fced y he firm nd he sysem. his my implicily downply he scle of unceriny in he sysem s firms my fce heerogeneous shocs o emission levels from hose fced y he sysem.

16 igure 4 gives imeline of he model we consruc, illusring he hree periods nd he cions of he firm in ech period. Emission Shoc X Emission Shoc X irm underes invesmen progrmme nd mes iniil invesmen in echnology irm mes second invesmen in echnology irm srs o opere new echnology irms operes expnded echnology sed on second invesmen eriod eriod eriod igure 4: imeline of he model One of he ey quesions in compring insrumens is he sis for comprison: wh is he suile x level for evluion wih cp-nd-rde schemes. he choice of he x level, lie he decision on where o se he cp, is essenilly poliicl decision nd sujec o wider rnge of fcors. In our model we ssume h he governmen hs deermined he desired level of emissions nd ses E he level of he cp under ceriny ccordingly. When Cp seing x i ims o se i he level which, o he es of is nowledge, will mee his rge. We explore hree differen cses over how he governmen defines he x given his ojecive: Cse : he x is se he level necessry o mee he cerin level of emen in he reference scenrio, wih no new echnology, nd remins unchnged wheher he firm invess or no. his implies lrger reurns o he cp-nd-rde scheme under ceriny s he firm enefis oh from he drop in permi prices due o he inroducion of he new echnology nd from he need o purchse fewer llownces. Cse : he x is se he level necessry o mee he desired level of emen ssuming he mximum emen from he new echnology, if invesmen is underen. his essenilly ssumes h he governmen is opimisic wih regrd o he implemenion of he new echnology nd only oserves he es-cse scenrio. Cse : he x is se he men level of he cron price upon implemenion of he new echnology, nd es ino ccoun he 4

17 uncerinies over he finl level of emissions. Due o he convexiy of he emen funcion his is higher hn he level of x h is required given cerin level of emen. he choice of x eween he hree cses is, in essence, deermined y he speed of djusmen of he governmen o new echnologies nd he level of informion ville. he firs cse represens where here is no, or exremely delyed djusmen once new echnologies pper; he second when here is no unceriny en ino ccoun; nd he hird, where he governmen oserves he echnology nd he unceriny u cn only se he level of x once every period. One insrumen h hs een proposed o improve he performnce of cp-ndrde schemes is he use of price floors nd ceilings. loors my e operionlised y seing reserve price on ucions Hepurn e l. 006, Gru nd Neuhoff 006. Opion conrcs re n lernive mechnism hrough which floors could e inroduced. Ceilings cn e inroduced y commimen o relese exr llownces ino he sysem when he ceiling is reched. We inroduce price floors nd ceilings o he cp-nd-rde scheme in order o exmine he impc of hese insrumens. 4. D Descripion We prmeerise he model wih wo exmple echnologies, Biomss for elecriciy nd CCS, he specific deils of which re discussed elow. We choose he firm size o pproximely mimic he size of lrge diversified energy supplier, nmely EON, nd we se he sysem o pproximely mch he reminder of he operors under he EUES. We define he inpu d nnully nd ssume h ech period,, is of five yers durion, wih oh cos d nd reurns delineed in 005 US$. We ggrege nd discoun nnul surpluses ino ol surpluses for ech period nd use he weighed-verge cpil cos o EON efore xes s he discoun re 9.%. We drw emen funcions for oh he firm nd he sysem from he IIS GGI scenrio dse IIS 007. he scenrio provides discree poins for shdow prices of GHG nd emissions for Europe s whole, from which we drw coninuous funcion. We scle his down o fi he size of he EUES relive o Europen emissions in ol. We ssume h he firm represens pproximely 5% of he ol rding scheme pproximely he size of EON By doing so, we re implicily ssuming h he EUES hs he sme miigion opions ville o i s Europe s whole, nd h he firm hs he sme opions s he sysem. his is n srcion given h i is liely here re numer of lower-cos miigion opions ville o Europe energy efficiency eing perhps he cleres exmple.we use d for oh WEU nd EEU which lso include non-memer ses, lni, Bosni nd Herzegovin, Croi, YR Mcedoni, Seri, Swizerlnd nd urey. We scle he funcion y hlf o reflec he size for he ES compred o he ol re, nd lso he reflecion h more of he emen is liely o occur in he ES compred o he re s whole. 5

18 nd we scle he emen funcion ccordingly. We se declining cp over he hree periods for emissions similr o h conceived for he EUES phse III. In defining he scle of unceriny in oh emissions nd echnology, we drw upon previous lierure. We use wor from previous esimions of fuure ES emissions o deermine he pproxime scle of unceriny over emissions CmEcon 009. We choose n pproxime rnge of 0 M CO yer for he sysem s whole wih firm unceriny scled ccordingly. he specific shocs o he firm s emissions we ssume re: Shoc in eriod X ~ N0,.5 Shoc in eriod X ~ N0,.5 Covrince of shocs δ = 0. 5 We choose hese disriuions in order o give oh he rnge of unceriny h we discuss ove nd lso idenicl vrinces in oh periods. We summrise he d for ll vriles nd he form of ll funcions in nnex. s discussed ove, in compring cp-nd-rde wih x, here re vrious opions for defining x levels. In le we show he levels of cron x we derive for ll hree cses of x formion nd for he wo differen echnologies. x Cse x Cse Wihou Invesmen x Cse Wih Invesmen Biomss x Cse Wih Invesmen CCS x Cse Wihou Invesmen x Cse Wih Invesmen Biomss x Cse Wih Invesmen CCS eriod eriod eriod le : Levels of Cron x $/CO here hs een relively lile wor conduced on wh levels insrumens such s price floors nd ceilings should e se, hus we chose o se floor nd ceiling o cu off cerin percenge of he disriuion of cron prices. We se floor price o cu off he oom 0% of he frequency disriuion of cron prices, given he uncerinies discussed ove, nd price ceiling h cus off he op 0% of he frequency disriuion of prices. he susequen resuls should hus e seen only s n indicion of he poenil impc of inroducing floor or ceiling nd no s represening ny priculr opionliy or expecion. rice loor rice Ceiling eriod eriod le : Levels of rice loor nd Ceiling $/CO hus we se he sndrd deviion o pproximely 0 M CO so h 95% of oservions fll wihin his rnge hese vrinces imply sndrd deviion of.80 for he sysem s whole, reflecing he rnge of esimes of emissions projecions. 6

19 4. Biomss We firs run our model for elecriciy-genering iomss plns. hese hve similr cos srucure s ssumed in our model in erms of significn cpil nd susequen opering coss. Biomss for power is relively mure echnology wih relively low unceriny over he echnology involved. here re sill lrge quesions, however, over he supply chin for he fuel inpus nd he lod fcor which such plns could opere. 4 We ssume h he firm operes he echnology s selod, opering i wihou reference o he cron price. If he price of cron,, flls elow he opering coss of he echnology,, he firm operes iomss over he mos expensive emen opions i would hve underen wihou he echnology. We use reference scenrio invesmen of 500MW supercriicl col-pln drwing on d on cpil coss, opering coss nd emissions from he Inegred Environmenl Conrol Model IECM We drw d for iomss for cpil nd opering cos from sudy y Cpuo e l 005, nd sudy y he Europen Commission 008. We esime ddiionl cpil invesmen $90 million for consrucion of 0 50MW iomss fired power plns 6 in comprison o he reference scenrio. Esimes for he rnge of opering coss re drwn from oh sudies nd he rnge oserved here hve led o us choosing disriuion for he emen cos s: emen cos of Biomss for power $ per on cron ~ N 4,9 s emissions from iomss do no hve o e ccouned for under he EU ES, emen is equl o he emissions produced y he lernive invesmen, he supercriicl col pln. We ssume h here is unceriny over he lod fcor for he iomss pln, which relises iself s unceriny over he level of emen vis-à-vis he lernive invesmen 7. We model his unceriny wih uniform disriuion: 4 We me he ssumpion h he firm does no fce consrins over he supply chin for he iomss power pln nd hus cn opere he pln s selod generion. 5 Due o he esime se lod for he iomss plns he cul size of he pln is 596.5MW. We use he sndrd ssumpions in he IECM model for SCRESGD pln, wih he excepion of he col price which we mend o $70/ in order o reflec he higher prices in he EU. 6 his is sed upon d from Cpuo e l. 005 for cpil invesmen in 0 50MW plns uilising fluid ed composiion followed y sem urine cycle generion, using iomss composed of griculurl crops y-producs, gro-indusril nd wood wses. 7 We implicily imply here h he firm cn produce he sme moun of produc despie vrying lod fcor, his my imply he use of smll mouns of fossil fuel inpu nd hus reduce he emen h is possile vis-à-vis he reference pln. 7

20 ~ U.,. ~ U6.6,9.6 where he upper ound of emen is sed upon emissions from he reference pln drwn from IECM 006. he invesmen funcion, I, is prmeerised s liner funcion using he upper ound level of emen wih he figure for ddiionl cpil invesmen. We ssume lerning curve h ffecs his invesmen funcion h depends on he cul relision from he iniil invesmen. Cpil coss fll y pproximely 5% from full relision of emen, declining s he relision flls for full prmeerision see nnex. 4. CCS CCS is n ddiionl echnology, whose cos nd ris srucure is rodly pproprie o our model srucure. I is echnology h is liely o require lrge iniil invesmens in erms of cpil/lerning coss, u will lso require significn opering coss eyond his invesmen. he iniil invesmen my open opporuniies for wider deploymen of he echnology, nd my e exernlly funded, les prilly, hrough governmen suppor. CCS is n immure echnology, in comprison wih iomss for power, wih greer unceriny over coss nd performnce. long wih his greer scle of unceriny CCS hs furher differences from iomss. In h i is no cenrl o generion of he produc i is possile for he emen echnology o e swiched off whils he produc cn sill e produced. his my e he cse if he cron price flls elow he level of opering cos of he echnology. Wih his in mind we me n mendmen o he model used for iomss o llow he firm o choose o e or no depending on he cron price nd he opering cos of he echnology. 8 In is operion CCS consumes percenge of pln s oupu, implying h fcors such s he elecriciy-cron price spred will ply role in is invesmen incenives nd decision o opere. 9 By llowing ound of unceriny over he opering cos of he echnology, which includes coss of forgoing elecriciy we implicily include his fcor, u do no model elecriciy prices explicily. 8 he mendmen o he equions re oulined in nnex. 9 CCS is relively unique echnology in h i is consumes some of he oupu of he pln when i is in operion, consuming roughly hird of he pln s supply. his cn e recovered, however, y swiching off he echnology. hus, he choice eween opering he pln wih nd wihou CCS depends on wh he firm cn gin from selling he exr oupu, versus he exr cos i incurs from he cron price. or insnce, when cron prices re low nd i is uneconomic o run he echnology, he firm cn gin from producing nd selling he exr elecriciy. 8

21 We drw d, for cpil invesmen, opering coss nd emen from IECM 006 nd minin he reference scenrio s n invesmen in 500MW supercriicl col pln 0. ddiionl cpil invesmen for consrucion of pln wih CCS is $450 million, which covers oh he cos of he CCS nd he cos of consrucing lrger pln which is required o mch he oupu of he reference pln due o CCS consuming percenge of he pln s oupu. or he rnge of unceriny regrding he echnology, we surveyed rnge of lierure IECM 006, IE 008, ICC 005, Ruin e l. 007, McKinsey 009 nd chose n pproxime scle of unceriny sed upon he rnge of esimes given. Opering cos of CCS, in $ per on cron emen ~ N 5,5 emen for CCS, MCO is lso drwn from hese sudies nd deermined in comprison o he pln wihou CCS. he disriuion chosen is: ~ U, wih he upper ound drwn from emen level from IECM 006. We prmeerise he invesmen equion in he sme mnner s for iomss nd ssume he sme lerning curve over cpil invesmen. 5. Resuls We run Mone-Crlo simulions of 50,000 oservions ech, for oh echnologies, for he hree cses of x formion nd for cp nd rde schemes wih nd wihou he use of price floors nd ceilings. We oin ne presen vlue surpluses under he vrious insrumens, which we ggrege ino hisogrms o oin disriuion of ne presen vlue surplus reurns. ull resuls cn e found in nnex. We find h in wo ou of hree cses, cp-nd-rde schemes genere higher men, u lso greer disriuion in, reurns over invesmen hn under x regimes. his higher men is eviden when he x is se s per Cse nd, wih he x showing slighly higher men when he x is se s per Cse. In cp-nd-rde scheme he price dps o ses of he world where emissions re higher or lower hn expeced. he convexiy of he mrginl 0 We compre eween super-criicl col pln of 500MW wihou CCS nd 66.4MW pln wih CCS o ensure h he nnul power generion is equivlen, following he sme ssumpions s he reference pln in he iomss cse. Noe h he resuls for ech echnology re drwn from six sepre simulions. he repored resuls for he cp nd rde scheme nd cp wih floor re drwn from he sme simulion s for x Cse. he comprison of reurns over invesmen eween insrumens uilise he resuls for he cp nd rde scheme in he differen simulions. here re smll differences eween hese simulions, hus he resuls for he comprison eween insrumens my no lly wih he reurns over invesmen. 9

22 emen curve implies h in our model higher hn expeced emissions drive cron prices higher hn hey would fll due o lower hn expeced emissions. s hese cron prices re ey deerminn of he reurns o he echnology he higher reurns under higher hn expeced emissions ouweigh he lower reurns when here re lower hn expeced emissions. he x is unle o djus o hese chnges in expeced emissions. 5. Resuls for Biomss When we pply he model o iomss for power we oserve posiive men reurns under ll insrumens. Under x, se s per cse, men reurns over invesmen re $9 million wih sndrd deviion σ of 88 million wih zero or greer reurns oserved in 99% of cses. Under cp nd rde scheme men reurns over invesmen re $657 million σ=87 million wih zero or greer reurns oserved in 78% of cses. he cp in comprison o he x generes greer verge reurn of $467 million, wih he cp genering greer or equl reurns in 7% of cses. When we mend he x o cse, we ssume he governmen hs nowledge regrding he echnology nd ses xes sed upon he upper ound of emen rising from i. In his cse he verge men reurn over invesmen under he x increses o $669 million σ=9 million. he dvnge of cpnd-rde schemes over xes decreses in his cse s oh he x level nd he price of cron djus o he inroducion of he echnology. We oserve h he x provides n verge surplus of $0 million over cp-nd-rde σ=85 million, wih he cp genering greer or equl surpluses 47% of he ime. Wih our finl mendmen o he process of x formion, where he governmen hs nowledge of he echnology nd lso he scope of he unceriny, we oserve h he reurns under he x over invesmen reduce o n verge of $65 million σ=99 million. he dvnge of cp-nd-rde schemes over x reurns wih men reurn over he x of $ million σ=80 million, wih he cp genering greer or equl surpluses 48% of he ime. igure 5 shows he disriuion of he reurns we oined over invesmen for he x under cse nd cp-nd-rde scheme. We exmine he use of price floors nd ceilings s mendmens o sndrd cpnd-rde schemes. When we compre he insrumens, we find h he scheme wih he floor generes greer reurn vis-à-vis he x compred wih he sndrd scheme. he inroducion of price floors rises he men reurn of invesmen y $5 million σ=48 million wih respec o he sndrd cp-nd-rde scheme, wih reurns greer or equl in 9% of cses. he floor cuses hese effecs y reducing he lower end of reurns when emission shocs re negive nd cron prices collpse, s prices only fll o he level of he floor. 0

23 rice ceilings reduce he dvnge of cp-nd-rde schemes over xes wih reurns lower hn xion in wo cses. Wih price ceilings nd floors we oserve h he men reurn o invesmen flls, wih he insrumen wih floors nd ceilings producing men reurns h re-$87 million σ 55 million lower hn sndrd scheme. his is due o he fc h he ceiling reduces he numer of cses when high surpluses re oined, s high cron price scenrios re removed. Despie hese effecs he insrumen wih ceilings nd floors generes greer reurn hn xes in he mjoriy of cses where, due o he floor reducing low reurns from low cron price scenrios. igure 6 illusres he reurns over invesmen under he x in cse, in comprison wih he sndrd cp-nd-rde scheme nd scheme wih floor nd ceiling. here re wo cler spies in he disriuion round he level of reurns ssocied wih cses of he world where eiher he floor or ceiling is enced in oh periods, i.e. he spie he lef hnd side of he disriuion is ssocied wih floors eing cive in oh periods, nd he spie on he righ hnd side is reled o ceilings eing enced in oh periods Numer of oservions Reurn M$ x over Invesmen Cp over invesmen igure 5: Disriuion of reurns over invesmen under x cse nd cp nd rde scheme

24 Numer of oservions x Cp Cp wih floor nd ceiling Reurns M$ igure 6: Disriuion of reurns over invesmen for x, cp-nd-rde nd cp nd rde wih floor 5. Resuls for CCS When we pply our model o CCS we find h, under he ssumpions we hve mde, men reurns from he echnology re negive under ll cses of x formion. he men reurns vry eween -$66 million under cse o -$0 million under cse. In ll cses we find less hn 0.0% oservions of zero or greer reurns. We find h sndrd cp-nd-rde scheme generes men reurn of -$07 million over invesmen, wih sndrd deviion σ of $467 million. osiive oservions re oserved % of he ime. When compring he reurns under cp-nd-rde scheme in comprison o x under cse we find h he cp generes greer or equl reurn in 48% of cses, wih greer men surplus of $40 million. hese resuls underline h he levels of cp nd cron x levels poenilly deed, re in generl insufficien o me CCS invesmen economic over he nex 5 yers wihou governmen suppor. his is in sr conrs o he resuls for iomss where, for he ssumpions we me, oh cps nd xes genere posiive men reurns in ll cses. Despie he negive reurns he choice of insrumen does hve srong ering on he size of defici nd hence he scle of ddiionl suppor h my e required. In igure 7 we compre he disriuion of reurns under cp-nd-rde scheme nd x deermined s per cse. We oserve spie in oservions for he cp-nd-rde scheme, cused y he lrge moun of cses where he cron prices is no high enough, in eiher period, o opere he echnology nd

25 hus he surplus is equl o he invesmens in he echnology. In he x cse we do no oserve his s he x level is sufficienly high so h in les one period i is higher hn he opering cos nd hus he echnology is opered Numer of oservions x Cp Reurn M$ igure 7: Disriuion of reurns under x cse nd cp-nd-rde scheme compred o invesmen When we inroduce price floors nd ceilings o he cp-nd-rde scheme, we oserve similr resuls o hose found under iomss. We find h he scheme wih he floor generes greer reurn compred wih he sndrd scheme reurns re on verge $ million higher σ =8 million nd generes greer or equl reurn in 94% of cses. When we inroduce he ceiling long wih he floor, he verge reurn from he insrumen over sndrd cp-nd-rde scheme flls o -$7 million σ 69 million lhough 6% of he ime he insrumen sill generes greer or equl reurns hn sndrd cp. igure 8 compres he disriuion of reurns under x, cp-nd-rde nd cp-nd-rde wih price floors nd ceilings.

26 Numer of oservions x Cp Cp wih floor nd ceiling Reurn M$ igure 8: Disriuion of reurns over invesmen for x, cp-nd-rde nd cp nd rde wih floor nd ceiling 6. olicy Implicions Our comprison of he differing firm-level incenives o invesmen in new echnologies produced y differen insrumens offers rnge of insighs for policy. he iliy of cron prices o rec o uncerin ses of he world produces, in wo cses of x formion, higher verge reurns for cp-nd-rde schemes hn for x regimes. hese reurns re driven y ses of he world wih high cron prices, driven y higher hn expeced emissions. he verge reurns from he cp-nd-rde scheme re ssocied wih higher disriuion of reurns hn under xes, hus he ris-preference of he firm mus e en ino ccoun when deducing which insrumen crees he greer overll incenive for invesmen. In sndrd economic heory, firms require higher reurns when here is higher ris. Wheher he higher reurns on verge under cp-nd-rde re enough o couner-lnce he higher ris is uncerin nd herefore, so is wheher cpnd-rde schemes ruly give greer incenives. Given h floors oh increse he verge nd reduce he disriuion of reurns, hey re liely o improve he incenives for invesmen from cp-nd-rde schemes whever his ris preference, lhough hey my increse he cos of complince for he firm s whole. he effec of ceilings is more miguous. lhough hey reduce he overll disriuion of reurns, hey lso reduce he verge reurn, nd i is no cerin which of hese effecs domines wih regrd o he overll incenive o invesmen. I is imporn o sress h invesmen mus lso e plced in conex of he wider riss fcing he firm. We find h reurns o low cron invesmen re 4

27 highes under cp-nd-rde scheme when emissions re heir grees due o posiive shocs. I is liely h his will occur when he economy is srong nd demnd for elecriciy is high. his implies h reurns o such invesmen re highes when revenues for he firm re liely o e heir highes, hus mplifying he ris fced y he firm. In conrs i is in hese imes h he coss of complince wih he cron policy re lso liely o e highes, so invesmens in such echnologies cn help hedge some of he ris ssocied wih such complince. here is quesion s o how prole ses of he world wih higher hn expeced cron prices re. In wo cses so fr EU ES phse I nd phse II here hve een drmic price flls cused, les in pr, y over-llocion of emission permis. here re cerin miiging circumsnces for his. hse I ws essenilly ril nd hus he over-llocion cn e seen s pr of he lerning experience; while phse II hs en plce wihin he cdrop of he lrges economic recession in living memory. Despie his here re quesions s o wheher he disriuion of emissions should e modelled s per norml disriuion or wheher here re longer ils on he downside hn he upside. his my e he cse if here re sysemic resons why emissions or he projeced coss of meeing cps re overesimed, cusing cps o e se oo high for discussion of such resons see Gru nd errrio 006. he choice of he x level, lie he seing of he cp, is poliicl decision nd hus sujec o wide vriey of fcors. We exmine differen mehods for x formion nd find h he performnce vis-à-vis he cp-nd-rde vries ccordingly. We vry he x sed upon hree differen cses, where governmens hve vrying iliy o predic fuure echnologies nd clcule unceriny. We find h xes perform es when governmens me he mos opimisic ssumpions regrding he echnology. Given he ineri ofen in plce in governmen regulion nd x-seing, i is quesionle how well governmens cn se xes h e ino ccoun hese fcors, nd hus how well he x cn perform in prcice. Cp-nd-rde schemes re ssocied wih greer disriuion of reurns, nd hus greer degree of ris. rice floors nd ceilings re wo insrumens h cn e used o miige some of he ris ssocied wih cp-nd-rde schemes s hey remove ses of he world wih very low or very high cron prices. he use of floors in our model reduces he disriuion of reurns nd increses he verge reurn over sndrd cp-nd-rde scheme in he rnge of $-59 million NV for he levels chosen, hus improving incenives for invesmen no mer he ris preference of he firm. he use of ceilings reduces he disriuion of reurns nd lso decreses he verge reurn y pproximely $40-90 million NV over cp-nd-rde schemes for he levels chosen, hus is effec on invesmen incenives is miguous nd depends on he firms ppeie for ris. he inroducion of price floors nd ceilings o cp-nd-rde schemes rises he prospec of compeing incenives. irms my prefer price ceilings s hey cn cp he cos of complince wih he cron policy, ye hey reduce reurns o 5