Real Options Analysis for “Green Trading”: The Case of Greenhouse Gases

To address the issue of reducing emissions of greenhouse gases, organizations are involved with emergent markets for trading emission permits. Investment in equipment that reduces emissions may generate emission credits for sale in the market. This article applies real options analysis to actual case study information from British Petroleum-Amoco of a particular project that would generate emissions credits. We conclude that unless permits have a faster price rise than is generally anticipated, certain projects are not economically feasible. The policy implication is that planners may need to set more stringent regulations to bring about their desired result. Additionally, real options analysis in this market based regulatory policy is an especially important tool for the energy industry, which is disproportionately impacted by greenhouse gases policies.

BIOGRAPHICAL SKETCHES

Joseph Sarkis is currently a Professor of Operation and Environmental Management in The Graduate School of Management at Clark University. He earned his Ph.D. from the State University of New York of Baffalo. His research interests include multiple criteria decision making, supply chain management, management of technology, environmentally conscious operations and logistics, performance management, justification issues, and enterprise modeling. He has published over 175 articles in a number of peer reviewed academic journals, conferences and edited books. He serves on a number of editorial boards for internationally recognized journals.

Maurry TAMARKIN earned a Ph.D. in Finance from Washington University in St. Louis. He is an Associate Professor at Clark University in Worcester, MA. He has published in Journal of Finance, Journal of Financial Economics, Journal of Risk and Uncertainty, Journal of Political Economy, Management Science, and Engineering Economist, among other journals.

Notes

¹Cap-and-trade schemes are discussed later, but these schemes are policies that set a limit on emissions by an organization (state, company, etc.) for different units within that organization (or region). This limit is the “cap” on the amount of pollutants that may be released based on some agreement, this cap may also be defined as the amount of pollutants or emissions permitted to be released. The “trade” allows for trading of emissions permits to other organizations or entities for some form of reimbursement.

²Even though the Kyoto Protocol has been ratified by a large number of countries, some countries have still not approved it, most notably, the U.S. has not ratified this protocol. The protocol, after Russia's acceptance, went into effect in signatory countries as of February 2005.

³Annex B countries are primarily developed countries and are listed in Annex B of the Kyoto Protocol along with the reduction amounts required of these countries. Annex B countries are: Australia, Austria, Belgium, Bulgaria, Canada, Croatia, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Italy, Japan, Latvia, Liechtenstein, Lithuania, Luxembourg, Monaco, the Netherlands, New Zealand, Norway, Poland, Portugal, Romania, Russian Federation, Slovakia, Slovenia, Spain, Sweden, Switzerland, Ukraine, the United Kingdom of Great Britain and Northern Ireland, and the United States.

⁴Initially the EU favored eco-taxes with which they have had significant experience. It was the U.S. that fought for emission trading as a possible option for cutting greenhouse gases [14].

⁵Annex I countries and Annex B countries are the same countries except that Annex I countries include Belarus and Turkey. Annex I countries are those countries included in Annex I to the United Nations Framework Convention on Climate Change, adopted in New York on 9 May 1992. Annex B countries refers to those countries included in Annex B in the Kyoto Protocol.

⁶The $1 per ton rate has been a historical level of some trading that has occurred at a smaller scale between the years 1991 to 2000 [30]. The $1 rate is without compliance pressures and voluntary systems. As more regulations are introduced these costs are expected to increase greatly. Yet, not all countries may adopt the Kyoto protocol where regulatory mechanisms may not be introduced, as is the case of the U.S. The $50 rate is the level where all exercise periods are in the first year.