December 13, 2010

Risk Aversion and CO2 Regulatory Uncertainty in Power Generation Investment: Policy and Modeling Implications

by Lin Fan, Benjamin F. Hobbs and Catherine S. Norman

- Our simulation considers producers in a competitive energy market. Risk averse producers face uncertainty about future carbon regulation. Investment decisions are a two-stage equilibrium problem. Initially, investment is made under regulatory uncertainty; then the regulatory state is revealed and producers realize returns. We consider taxes, grandfathered permits and auctioned permits and show that outcomes vary under risk aversion; some anticipated policies yield perverse investment incentives, in that investment in the dirty technology is encouraged. Beliefs about the policy instrument that will be used to price carbon may be as important as certainty that carbon will be priced. More generally, a failure to consider risk aversion may bias policy models of the power sector.

Fan, L., B.F. Hobbs and C.S. Norman (2010). "Risk Aversion and CO2 Regulatory Uncertainty in Power Generation Investment: Policy and Modeling Implications." EPRG Working Paper 1014, May 2010.