Real option analysis for effects of emission permit banking on investment under abatement cost uncertainty

The present paper analyzes the investment effects of emission trading scheme (ETS) when emission permits are bankable and there is technological uncertainty with regard to the abatement cost. A real option model is employed to accommodate irreversibility of investment and cost uncertainty. In the absence of abatement cost uncertainty, a bankable ETS reduces a firm's incentive for environmental investment, because the firm can utilize the banked permits for future compliance which act as substitutes for abatement investment. However, when cost uncertainty is prevalent, investment may reduce the opportunity cost of irreversible investment under the banking system, thereby increasing a firm's investment incentive. The condition is derived under which a bankable ETS provides higher investment incentives than a non-bankable ETS does.

► The paper analyzes effects of emission banking when abatement cost is uncertain. ► Real option model is provided to consider irreversibility and cost uncertainty. ► Bankable and non-bankable permit schemes are compared for investment incentives. ► With no uncertainty, a bankable ETS reduces investment incentive. ► With prevalent uncertainty, banking may facilitate investment compared to non-banking.