Permits vs. Offsets Under Investment Uncertainty

Abstract

This paper investigates interaction effects between permit and offset schemes, using the framework on Reducing Emissions from Deforestation and Forest Degradation (REDD+) as a test bed for evaluating the cost and benefit of including low-cost offsets in mandatory emission trading schemes. We use a real options model of firm-level investment decisions under stochastic prices to compare alternative emission trading and permit-offset linkage schemes. By isolating the critical design factors that drive energy investments, we seek to identify policy regimes that balance the different concerns in the polarized debate for and against the inclusion of offsets. Our findings indicate that a moderate offset quota is sufficient to contain investment crowding-out effects, while it still has a positive effect on profit distributions. In contrast, the classical permit price collar will not effectively change investment behavior, precisely because in a framework with multiple compliance instruments the volatility of cheaper offsets is the driving force for investment. Under these conditions, a price collar for offsets emerges as a largely overlooked policy option to foster investment incentives. A combination of offset quota and offset price collar leads to investment patterns that are almost identical to a regime without access to offsets.