Electricity capacity investment under risk aversion: A case study of coal, gas, and concentrated solar power

The policy instrument many economists favor to reduce greenhouse gas emissions and to shift new investment towards low carbon technologies is the tradable allowance system. Experience with this instrument has been mixed, with a crucial design issue being the choice of whether to auction allowances to firms, or to grandfather them based on historical emissions. In this paper, we examine the changing incentives of investment in different technologies, when investors are risk averse and are expecting an allowance system with a certain allocation rule but do not know if the policy is going to take place in the near future. Investors also cannot fully predict future investment costs for the low-carbon technology. We apply a game theoretic model to examine the combined effects of uncertainty and risk aversion on the actions of potential investors into high and low carbon generating capacity, under both allocation rules and uncertain costs. We find that uncertainty and risk aversion do have implications towards investment incentives. We discuss policy implications of these findings.

► We examined capacity investments under alternative carbon permit allocation schemes. ► Uncertainty in future permit markets' existence reduces investments into renewables. ► If permits are grandfathered, risk averse companies decrease renewable investment. ► Risk aversion minimizes the effects of uncertainty if carbon permits are auctioned.