Working Paper | HBS Working Paper Series | 2014

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 technology choice and capacity decisions. We show that emissions price uncertainty under cap-and-trade results in greater expected profit than a constant emissions price under an emissions tax, which contradicts popular arguments that the greater uncertainty under cap-and-trade will erode value. We further show that two operational drivers underlie this result: i) the firm's option not to operate, which effectively right-censors the uncertain emissions price; and ii) dispatch flexibility, which is the firm's ability to first deploy its most profitable capacity given the realized emissions price. In addition to these managerial insights, we also explore policy implications: the effect of emissions price level, and the effect of investment and production subsidies. We illustrate the context-dependent effects of subsidization through an example grounded in peak-load power generation. We show that production subsidies of higher investment and production cost technologies (such as carbon capture and storage technologies) have no effect on the firm's optimal total capacity, but that investment subsidies of these technologies increase total capacity, conditionally increasing expected emissions.

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. (Revised October 2014.)