Options on low-cost abatement and investment in the energy sector: new perspectives on REDD

Abstract

Deforestation is one of the major sources of carbon emissions, but the Kyoto Protocol presently excludes avoiding these emissions to fulfill stabilization targets. Since the need for policy incentives for the reduction of emissions from deforestation and degradation (REDD) was officially recognized in 2007, the focus of this debate has shifted to issues of implementation. Concerns about the effects that the availability of low-cost REDD credits might have on energy investments, and the development of clean technology constitute the main motivation of this paper. We analyze the production side of the problem with the help of a real options model with an option to invest in less carbon-intensive energy technology and an option to purchase credits on REDD, which will (or will not) be exercised in the future. Unresolved questions can thus still be addressed later, while producers and investors hold REDD options to maintain flexibility for later decisions.

The Clean Development Mechanism, Stochastic Permit Prices, and Energy Investments

“…For EUA prices we follow current results in the literature that attempt to model their price development (Yang et al, 2008;Fuss et al, 2008Fuss et al, , 2009Fuss et al, , 2010, by assuming the price development to follow a geometric Brownian motion (GBM) with a positive trend. The basic reason for using GBM to model the price process, is that it is generally expected that prices for allowances will reach a higher long-term price than the current one, despite possible price reductions from time to time.…”

“…In accordance with the literature we assume a 5% trend for the EUA price process (Yang et al, 2008;Fuss et al, 2008Fuss et al, , 2009Fuss et al, , 2010.…”

“…This is the current standard in the literature for sCER and sCER like permits (Yang et al, 2010;Fuss et al, 2010). For sCER prices we assume a 2% trend.…”

“…Also, due to the relatively short existence of permit markets, especially in the case of CDM permits, there is no long-term data available (Fuss et al, 2010). We take current future prices of EUA and sCER as a point of departure 12 .…”

Permits vs. offsets under investment uncertainty

“…The key concern is that the availability of low-cost REDD+ credits -due to the low marginal costs of reduced forest emissions -may 'flood' the compliance market and 'crowd out' socially optimal mitigation efforts in other sectors (Fry, 2008;Murray et al, 2009) as well as investments and research and development into low carbon technologies (Bosetti et al, 2011;Fuss et al, 2011). 3 Such disincentives to mitigate and invest could in fact threaten the dynamic efficiency of the market and increase the overall costs of achieving long-term decarbonization targets.…”