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Inducing Clean Technology in the Electricity Sector: Tradable Permits or Carbon Tax Policies?

Abstract:
Tradable permits and carbon taxes are two market-based instruments commonly considered by policymakers to regulate pollutions. While a tax is fixed, predetermined by authorities, the uncertain permits price is driven by market dynamics, fluctuating with the prices of natural gas and electricity. Both instruments offer firms different incentives for adopting clean technologies. This paper explores the optimal investment timing when a coal-fired plant owner considers introducing clean technologies in face of these two policies using a real options approach. We find that tradable permits could effectively trigger adopting clean technologies at a considerably lower level of carbon price relative to a tax policy. Higher levels of volatility in permit prices are likely to induce suppliers to take early actions to hedge against carbon risks. Thus, offset and other price control mechanisms, which are designed to reduce permit prices or to suppress prices volatility, are likely to delay clean technology investments.

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Energy Specializations: Electricity – Markets and Prices ; Energy and the Environment – Climate Change and Greenhouse Gases; Energy and the Environment – Policy and Regulation

JEL Codes:
D42 - Market Structure, Pricing, and Design: Monopoly
Q54 - Climate; Natural Disasters and Their Management; Global Warming
E60 - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook: General

Keywords: Electricity generation, Clean technology, Tradable permits, Carbon tax, Energy policy

DOI: 10.5547/ISSN0195-6574-EJ-Vol32-No3-6


Published in Volume 32, Number 3 of The Quarterly Journal of the IAEE's Energy Economics Education Foundation.