Working Paper | HBS Working Paper Series | 2012

Technology Choice and Capacity Portfolios Under Emissions Regulation

by David Drake, Paul R. Kleindorfer and Luk N. Van Wassenhove

Abstract

We study the impact of emissions tax and emissions cap-and-trade regulation on a firm's long-run technology choice and capacity decisions. We study the problem through a two-stage, stochastic model where the firm chooses capacities in two technologies in stage one, demand uncertainty resolves between stages (as does emissions price uncertainty under cap-and-trade), and then the firm chooses production quantities. As such, we bridge the discrete choice capacity literature in Operations Management (OM) with the emissions-related sustainability literature in OM and Economics. Among our results, we show that a firm's expected profits are greater under cap-and-trade than under an emissions tax due to the option value embedded in the firm's production decision, which contradicts popular arguments that the greater uncertainty under cap-and-trade will erode value. We also show that improvements to the emissions intensity of the "dirty" type can increase the emissions intensity of the firm's optimal capacity portfolio. Through a numerical experiment grounded in the cement industry, we find emissions to be less under cap-and-trade, with technology choice driving the vast majority of the difference.

Keywords: Pollution and Pollutants; Governing Rules, Regulations, and Reforms; Technology; Production; Performance Capacity; Mathematical Methods;

Citation:

Drake, David, Paul R. Kleindorfer, and Luk N. Van Wassenhove. "Technology Choice and Capacity Portfolios Under Emissions Regulation." Harvard Business School Working Paper, No. 12-079, March 2012.