Working Paper | HBS Working Paper Series | 2015

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. Through an illustrative example, 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 when firms own a portfolio of both clean and dirty technologies, but that investment subsidies of these technologies increase the firm's total capacity, conditionally increasing expected emissions. A subsidy of a lower production cost technology, on the other hand, has no effect on the firm's optimal total capacity in multi-technology portfolios, regardless of whether the subsidy is a production or investment subsidy.

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 July 2015.)