Conference Agenda

The accumulation of carbon dioxide and other greenhouse gases (GHGs) in the atmosphere leads to a range of consequences, from rising global temperatures to extreme weather events, causing irreversible damage to ecosystems. To tackle the challenge of climate change, it is therefore imperative to reduce carbon emissions, which are the primary drivers of global warming. To this end, a range of sustainable practices, green technologies, and decisive policy measures must be adopted.

The EU Emission Trading System (EU ETS) is a cap-and-trade mechanism in which permits to emit are primarily auctioned or, to a lesser extent, allocated for free. These allowances can then be traded on a secondary market, where more (less) technologically advanced companies using clean (dirty) technologies can sell (purchase) excess (missing) permits. The operation of this scheme was divided into four phases, whose most relevant innovation is the introduction, since 2013, of a unique EU-wide emission cap. By decreasing the number of permits available, an upward pressure is applied to carbon price, incentivizing the adoption of more sustainable and less polluting technologies. Firm's decision to go green can then be shaped by the policy maker, exerting its influence on permit’s market price.

Our paper aims to contribute to the growing literature on carbon pricing by modeling this dynamic. Specifically, using a real options model and appropriate numerical simulations, we describe (i) brown firms' optimal choice for green investment under carbon price uncertainty and (ii) how this choice can be influenced, and ideally accelerated, by the policy maker by sustaining carbon price, reducing the number of permits auctioned or allocated for free. An additional contribution of our work is the use of a Geometric Brownian Motion (GBM) calibrated to real data to account for the uncertainty affecting firms' decisions. The calibration of the GBM describing carbon price to real market data, enables a more realistic depiction of the decision-making process. Our goal is then to support stakeholders, from policymakers to entrepreneurs, in implementing more robust and realistic action plans.

We believe this paper could contribute to both the scientific literature and the policy debate by presenting a rigorous model describing the green investment decision-making processes of individual firms and the consequent broader dynamics of the green transition. Our model shows how this transition can be effectively incentivized through targeted policy instruments. Additionally, through calibrated numerical simulations based on real data, we quantify the effects of different policy approaches, offering insights into their impact on both the timing of the energy transition and on emissions cut over a specified time frame. These findings aim to provide regulators with a tool for selecting and fine-tuning the most effective policy options to promote the green transition and achieve emission reduction targets.

The primary tool available to the policymaker for encouraging the green transition is a price floor, which is the central focus of this work. The potential introduction of a price floor in the EU ETS market is a topic under discussion, though the reduction in total allowances effectively acts as an implicit floor. Setting a price floor supports the green transition by both accelerating initial investments and achieving a higher level of emissions reduction by the end of the specified time horizon. By means of a set of numerical simulations, calibrated on real data, we quantify the impact of two possible designs of price floors that influence firms' investment decision-making processes differently. On the one hand, we analyze the effects of the well-known constant floor, while on the other hand we test a refined floor, designed to simulate the distortion induced by the massive amount of free allowances granted to hard-to-abate sectors. Our results can serve as a valuable tool for regulators, helping both in selecting the most appropriate type of price floor and in its fine-tuning, to meet specific objectives.

Despite its significance, the price floor is not the only lever available to regulators to promote a clean transition. Green investment cost has proved to be a very relevant driver, as a small variation have a relevant impact on investment cost and, therefore, can induce an anticipation or delay of months in the beginning of transition process. Reducing the cost to undertake the green investment could therefore represent an additional instrument to foster transition.

The volatility of the permits market price has a significant yet ambiguous effect on investment decisions. Specifically, as volatility increases, the investment trigger also rises, making the decision to invest less likely. However, this also increases the probability of reaching the trigger, with an opposite effect on investment decision. The overall impact depends on which dynamic is dominant and, within our framework, the first dynamic outweighs the second. Although not entirely under the direct control of regulators, policymakers can employ several approaches to help reduce market price volatility. On the one hand, the Market Stability Reserve (MSR) could absorb excess supply during periods of low demand, thereby stabilizing prices. Conversely, during periods of excess demand, adjustments to market liquidity could effectively reduce volatility. Finally, the interest rate can also serve as an instrument influenced by the regulator through monetary policy. Specifically, due to its effect on the present value of future costs, an increase (decrease) in the interest rate causes an upward (downward) shift in the investment trigger, thereby inducing a delay (acceleration) in the transition process.

Our findings on the two policy options, i.e. constant floor and refined floor, highlight distinct effects on the green transition. The constant floor delays the onset of the transition but achieves a greater reduction in emissions over the medium to long term, i.e., within 5 years. Conversely, the refined floor encourages earlier investment but results in a lower percentage of green firms over time. Therefore, the choice between these policy instruments ultimately depends on the policymaker’s objectives and priorities for the transition process.