Investors' reaction to the government credibility problem: A real option analysis of emission permit policy risk

- We study the effect of climate change policy risk on power plant investment.
- We extend the real option approach to study the government credibility risk.
- We shed light on operational flexibility in the presence of political risk.
- Government credibility risk on CO2 permits will reduce investment in green plants.
- Credibility issues with emission trading will either delay or hasten investment.

In relation to creating a CO2 emission permit market, there are two types of climate change policy risks: (1) It is uncertain whether and when a cap-and-trade system will be implemented; and (2) once a policy is in place, there may be government credibility issues. This paper examines the effect of these policy risks on real option decisions of electric power plant investment. To model both an investment decision and generation flexibility, this study evaluates an exotic compound American option on multiple strips of European spread options through the implementation of least squares Monte Carlo simulation. Government credibility risk leads to more investment in “less green” resources and induces additional cash flow variation, which increases the average time to investment (value of waiting). However, in an extreme case, government credibility can actually hasten investment because the risk may be more favorable to electric power companies. Furthermore, if emission trading is planned to be implemented in the future (e.g., 2020), and the market believes that the probability of successful implementation is low, firms will build a “less green” plant early to benefit from the period before the green rule is applied.