Flexible Options for Greenhouse Gas-Emitting Energy Producer

Abstract

The reduction of emissions from deforestation and forest degradation (REDD) constitutes part of the international climate agreements and contributes to the Sustainable Development Goals. This research is motivated by the risks associated with the future CO2 price uncertainty in the context of the offsetting of carbon emissions by regulated entities. The research asked whether it is possible to reduce these financial risks. In this study, we consider the bilateral interaction of a REDD supplier and a greenhouse gas (GHG)-emitting energy producer in an incomplete emission offsets market. Within this setting, we explore an innovative financial instrument—flobsion—a flexible option with benefit-sharing. For the quantitative assessment, we used a research method based on a two-stage stochastic technological portfolio optimization model established in earlier studies. First, we obtain an important result that the availability of REDD offsets does not increase the optimal emissions of the electricity producer under any future CO2 price realization. Moreover, addressing concerns about a possible “crowding−out” effect of REDD-based offsets, we demonstrate that the emissions and offsetting cost will decrease and increase, respectively. Second, we demonstrate the flexibility of the proposed instrument by analyzing flobsion contracts with respect to the benefit-sharing ratio and strike price within the risk-adjusted supply and demand framework. Finally, we perform a sensitivity analysis with respect to CO2 price distributions and the opportunity costs of the forest owner supplying REDD offsets. Our results show that flobsion’s flexibility has advantages compared to a standard option, which can help GHG-emitting energy producers with managing their compliance risks, while at the same time facilitating the development of REDD programs. In this study we limited our analysis to the case of the same CO2 price distributions foreseen by both parties; the flobsion pricing under asymmetric information could be considered in the future.

Keywords

• optimal energy mix
• co₂ emissions
• redd offsets
• risk-adjusted utility