Investing in Carbon Offset Projects under
Climate Policy Uncertainty:
a conceptual model
Mo Zhou
West Virginia University
1
In times of climate change
Forests
 offset CO2 through sequestration
 provide carbon-neutral feedstock for energy
production
 Key: Climate policy
- Carbon price
- Energy price
- Energy policy
2
International Efforts

Kyoto Protocol – binding commitments to 5%
reduction against 1990 level by 2012
 European Union Emission Trading Scheme

Market-based mechanisms for mandatory reduction

Copenhagen Accord: not legally binding
3
Clear Skies and Global Climate
Change Initiative



Bush Admin. 2002 policy
Goal: 18% reduction of GHG from 2002 to
2012
Incentives for voluntary reduction
- Chicago Climate Exchange (2003 -2010)
- Regional Greenhouse Gas Initiative (RGGI)
4
Waxman-Markey Climate Change Bill





American Clean Energy and Security Act of
2009 (H.R. 2454)
Market-based approach to GHG emission
reduction: CAP and TRADE
Passed by the House on 6/26/09
Yet to be passed by the Senate…
Boxer-Kerry bill?
5
Offset credits earned through
 Afforestation and reforestation
 Forest conservation
 Sustainable forest management
Offset credits tradable at market price –
affected by climate policy
6
Projected/Proposed Carbon Prices
($/tonne of CO2)



Council of Economic Advisers
$ 20
Empirical models
$ 18 ~ 260
Climate change bills
Price floor ($10, $11), price ceiling ($28)
7
Modeling Policy Uncertainty
through carbon price



Dramatic changes due to abrupt policy
changes: regime-switching model
Regime 1: S1 voluntary reduction
Expected carbon price PS1(assumed $5)
Regime 2: S2 mandatory reduction
Expected carbon price PS2 (uncertain)
8
Transition between regimes
Prob
Prob
Prob
Prob
(St
(St
(St
(St
=
=
=
=
1
2
2
1
|
|
|
|
St-1
St-1
St-1
St-1
=
=
=
=
1)
1)
2)
2)
=
=
=
=
p
1-p
q
1-q
Starting from regime 1, 1-p reflects uncertainty of
Regime change.
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

Baseline: no offset investment
fixed timber price
Max NPV of timber income
Scenarios: options of offset investment
fixed timber price
uncertain carbon price
Max NPV of combined carbon
and timber income
10
A simplified stand
State
Volume
(m3 ha-1)
Immediate net
return ($ ha-1) *
0
0
-494 (planting)
1
29
-117
2
274
3068
3
530
6396
4
728
8970
5
868
10790
For each state, options include doing nothing or cutting.
* Assuming a fixed timber price.
11
A linear-programming model
max NPV   Rik yik
i
k
subject to :
y
jk
k
 a  yik p  j i, k    j
yik  0
i
j  1,..., n
k
i, k
where,
1
a
(1  r ) D
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Baseline: Max NPV
At a discount rate of 3
percent, starting from
state 1, regime 1
NPV* = 8468.3 $ ha-1
State
Optimal
Decision
0
Plant
1
No Cut
2
No Cut
3
Cut
4
Cut
5
Cut
13
Offset options
.
State
Carbon
(t ha-1)
0
0
1
4
2
19
3
36
4
54
5
67


For each state, options
include doing nothing,
offset, or cutting
A fixed offset cost of
200 $ ha-1 was assumed
regardless of stand
state.
14
Under current carbon price $5/t
At a discount rate of 3 percent, starting from state 1
and regime 1:
NPV* = 8468.3 $ ha-1 ( equal to baseline)
Same optimal decision.
Thus, offset investment option has zero value.
15
Carbon price uncertainty


Regime 1: S1 voluntary reduction
Expected carbon price PS1 $5/t
Regime 2: S2 mandatory reduction
Expected carbon price PS2
Scenarios: $10, $28, $260 /t
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Uncertainty of Regime Switch
End: S1
Start:
S1
S2
Start:
S1
S2
S2
0.9End: S 0.1 S
1
2
0.1
0.9
End: S1
0.7
0.3
Start:
0.1
0.9
S1
0.5
S2
Start:
0.1
S1
S2
S2
End:S1
0.5
0.9
S2
0.3
0.7
0.1
0.9
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Regime 2: price floor 10 $/t
Option value of offset investment
600
400
200
0
1
2
Certainty
3 of regime
4 switch
r = 3%, starting from state 1 and regime 1
5
6
18
P = 0.9 and q = 0.9
(less certain switch)
NPV* = 8,675 $ ha-1
(2% increase)
P = 0.1 and q =0.9
(more certain)
NPV* = 9,068 $ ha-1
(7% increase)
Optimal decision
State
Regime 1
Regime 2
0
Plant
Plant
1
No cut
Offset
2
No cut
Offset
3
Cut
Cut
4
Cut
Cut
5
Cut
Cut
19
Regime 2: price ceiling 28 $/t
2000
Option value of offset investment
1500
1000
500
0
1
2
3 of regime
4 switch
Certainty
r = 3%, starting from state 1 and regime 1
5
6
20
P = 0.9 and q = 0.9
(less certain switch)
NPV* = 9,145.6 $ ha-1
(8% increase)
P = 0.1 and q =0.9
(more certain)
NPV* = 10,434 $ ha-1
(23% increase)
Optimal decision
State
Regime 1
Regime 2
0
Plant
Plant
1
No cut
Offset
2
No cut
Offset
3
Cut
Cut
4
Cut
Cut
5
Cut
Cut
21
Regime 2: 260 $/t
40000
Option value of offset investment
30000
20000
10000
Certainty of regime switch
0
1
2
Certainty
3 of regime
4 switch
r = 3%, starting from state 1 and regime 1
5
6
22
Optimal decision
p = 0.9 and q = 0.9
(less certain switch)
NPV* = 21,056 $ ha-1
(149% increase)
State
Regime 1
Regime 2
0
Plant
Plant
1
No cut
Offset
p = 0.1 and q =0.9
2
Cut
Offset
(more certain switch)
NPV* = 45,380$ ha-1
(436% increase)
3
Cut
Offset
4
Cut
Cut
5
Cut
Cut
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Conclusion




Options of offset investment have no
value under current carbon price.
Climate policy uncertainty creates
significant option values.
Option values increase as carbon price
increases.
Option values increase as regime switch
becomes more certain.
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