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

Abstract

In this paper we evaluate the simultaneous impact of two emission permit classes with stochastically evolving prices on energy investments. We consider permits that are allocated and auctioned inside the EU (EUA) and secondary Certified Emission Reductions permits (sCER), which are resold primary CER from the CDM. One price taking firm subject to emission regulation has the choice to invest in a wind power plant, a gas power plant or can choose do to nothing. An investment in either plant type is considered to be irreversible. When investing in the gas plant the investor also has to consider the future development of emission prices. We use Monte-Carlo simulation to generate price paths for the emission permits, which serve as an input for a recursive optimization problem. We find that allowing the usage of offset permits in the present policy framework leads to a significantly lower probability of an investment into wind power taking place. If the quota of sCER permits is doubled, the decrease in the investment probability into wind is more than proportional. Decoupling the price processes does not significantly alter the results. Since the CDM has been under a lot of criticism over the years, recently especially concerning its baseline-methodology and a subsequent over-supply of emission permits, policy makers should be careful in constructing new offset mechanisms without properly understanding the impact on investment behavior. JEL-Classification: C63,Q47

Explaining the EUA-CER Spread

“…Whereas the studies summarised so far are concerned with the price behavior, Hieroymi and Schüller (2015) investigate how the existence of different emission permit classes affects energy investments.…”