Impact of a Safety Valve in an Emission Trading System: A Real Options Approach

Abstract

For more than 20 years, cap-and-trade system has served as an efficient market-based mechanism to reduce emission of air pollutants such as sulfur dioxide and greenhouse gas. In this system, a limited amount of emission allowances are traded between affected firms with no price restriction. A potential problem arises when market demand of the allowances significantly surpasses market supply: allowance prices could boom to unexpected high level that jeopardizes the overall economy. Safety valve, an innovative mechanism, sets an upper limit of the allowance price and eliminates the risk of allowance price spike. Yet individual firms would bear less incentive to undertake substantial investment in costly emission reduction equipment. This paper analyzes how firms would change their investment strategy when we add a safety valve to a cap-and trade system. Since the allowance price evolution process is time dependent and does not follow the standard Geometric Brownian Motion, there is no analytical solution to this problem, hence we base our analysis on numerical analysis. Using a lattice model, we conclude that a safety valve would undoubtedly delay firms’ actual investment in emission reduction equipment. We also conduct sensitivity tests to analyze how would a firm’s investment strategy respond to change in some model parameters.