Risk aversion and CO2 regulatory uncertainty in power generation investment: Policy and modeling implications

We consider a simulation of risk-averse producers when making investment decisions in a competitive energy market, who face uncertainty about future regulation of carbon dioxide emissions. Investments are made under regulatory uncertainty; then the regulatory state is revealed and producers realize returns. We consider anticipated taxes, grandfathered permits and auctioned permits and show that some anticipated policies increase investment in the relatively dirty technology. Beliefs about the policy instrument that will be used to price carbon may be as important as certainty that carbon will be priced. More generally, a failure to consider risk aversion may bias policy analysis for the power sector.