Irreversible Investment under Uncertainty in Electricity Generation: A Clay-Clay-Vintage Portfolio Approach with an Application to Climate Change Policy in the UK
Adriaan van Zon & Sabine Fuss
#2006-035
UK climate change policy has long been concerned with the transition to
a more sustainable energy mix. The degree of competition in electricity
markets rises as these markets become more and more liberalized. In
order to survive in such an increasingly competitive setting,
electricity producers have to handle as efficiently as possible the
uncertainties associated with the volatility of fuel prices, but also
uncertainties regarding the technological evolution of electricity
production (including the development of renewable technologies).
Technological uncertainty in combination with high capital costs are
likely to deter investors from adopting renewable technologies on a
larger scale than they are doing right now, even though they have to
accept a higher degree of fuel price risk by doing so. By carefully
composing a portfolio of technologies with different (co-)variances in
the respective prices and rates of technical progress, risk-averse
producers can effectively hedge the uncertainties mentioned above. In
order to model this type of investment behaviour, we use an extended
version of the van Zon and Fuss (2005) clay-clay-vintage-portfolio model
that starts from the notion that investment in electricity production
equipment is irreversible. However, a physical capital portfolio - in
contrast to a portfolio of financial assets - can only be adjusted at
the margin. This implies that it becomes extremely important to look
ahead, and act on not just expectations themselves, but also their
reliability. Using the extended model, we implement several features of
present UK policy in order to illustrate the principles involved. We
find that the reduction of risk goes together with an increase in total
costs. We also find that for increasing values of risk-aversion,
investors would be willing to adopt nuclear energy at earlier dates than
otherwise would have been the case. In addition to this, we find that
the embodiment of technical change, in combination with the expectation
of a future switch towards another technology, may actually reduce
current investment in that technology (while temporarily increasing
current investment in competing technologies). The latter enables
rational but risk-averse investors to maximise their productivity gain
by waiting for ongoing embodied technical change to take place until the
moment they plan to make the switch and then investing more heavily in
the newest vintages associated with that technology at the time of the
switch.
UNU-MERIT Working Papers
ISSN 1871-9872