The effect of regulatory uncertainty and technological change on irreversible investments

Firms face uncertainties in their investment decisions due to rapidly changing conditions in the global market which includes competition, corporate social responsibility and the public’s perception of the firm’s activities, regulatory requirements, intellectual property rights, supply chain disruptions and technological innovation. This paper addresses how uncertainties in regulation and technology could impact irreversible capital investments. Regulatory uncertainty is attributed to a carbon tax levied on carbon present in every hydrocarbon fuel, i.e. petroleum, natural gas and coal. When these hydrocarbon fuels are burnt, carbon dioxide (CO₂) is released in contrast to the non-combustion energy sources – wind, sunlight, hydropower and nuclear. While a carbon tax on hydrocarbon fuels used as a source of energy would be the theoretically ideal regulatory instrument for the abatement of CO₂ emissions, substitution effects between different sources of energy could be realized through innovation in technology. I intend to model this mathematically and perform the empirical analysis in a long-run dynamic model using the geometric or arithmetic Brownian motion, a Weiner process. An alternate model that will be explored is the geometric Ornstein-Ulhenbeck Mean Reversion model.  Thus, changes in regulatory taxes on carbon, anticipated technological changes and the effect on irreversible capital investments would be modeled as stochastic processes. These events could be difficult to anticipate for investors.

Most environmental taxes in OECD countries are levied on energy products and motor vehicles rather than CO₂ emissions_. Recent studies on carbon tax include Meng (2013), Rozenberg (2013), Braunels (2012), Ruijs/Vollebergh (2013), Pillay/Buys (2013) and Nelson (2011). Niemann (2011) analyzed the impact of the uncertainty of nominal tax rates on irreversible investment. Schneider/Sureth (2010), studying capitalized investment with the option to invest and divest, showed that increasing tax rate may paradoxically increase an investor’s willingness to invest.  Panteghini/Scarpa (2003) analyzed mechanisms such as price caps or profit sharing and posit that regulatory risk may or may not affect investments decisions negatively. Paddock/Siegel/Smith (1988) focused on the option valuation of offshore petroleum leases as a function of the market price of oil. This paper contributes to the literature by analyzing the effects of stochastic carbon taxation and anticipated technological changes on investment behavior in a real options model. Though research on option pricing models in financial investments and natural resources abounds, this paper uniquely analyzes the joint impact of uncertainties in technology and taxes as a form of regulation on investment behavior.