Investment under uncertainty : EU renewable energy and climate policies beyond 2020

The prospects for EU renewable energy and climate policies beyond 2020 are uncertain. Investors and policy makers in Norway and abroad need knowledge on how to make decisions under this uncertainty. Firms' decisions under uncertainty can be formulated as a real option problem in which the option to delay an irreversible decision has a value. Policy as well as market uncertainty will affect this value. We derive decision rules. These rules can be used to form better forecasts of the power sector's decisions, and to assess the social welfare cost of different policy designs and uncertain political processes. A selection of the published research results so far: Subsidizing renewable energy is not the first-best instrument to mitigate greenhouse gases because it produces unintended and unwanted effects like too high consumption of electricity. Siddiqui, Tanaka and Chen (EJOR, 2016) show that these unintended effects can be reduced if the authorities simultaneously let coal and gas power companies exercise market power. These producers will then find it optimal to reduce their power production which will lead to lower emissions of greenhouse gases. The adoption of intermittent renewable energy technologies in Europe has resulted in higher ramping costs for conventional power plants and higher network congestion costs. Using a model of the powermarket, Virasjoki, Rocha, Siddiqui and Salo (2016) demonstrate that energy storage reduces the costs of ramping and congestion. However, energy storage may lead to increased carbon emissions if power companies behave perfectly competitively. This is because storage displaces relatively clean gas-fired plants, which are typically used to back up variability in renewable energy output, with relatively dirty coal plants, which have the lowest operating costs and are used to charge up storage. Linnerud, Andersson and Fleten in Energy (2014) investigated whether the prospects of a Swedish-Norwegian market for green certificates affected the timing of investments in small hydropower plants. The study was based on a survey among owners of licenses to construct such plants in 2010. They show that professional investors in the energy market acted in accordance with a real option investment rule, and the prospects of possible future subsidies delayed their investment decision. On the other hand, farmers and other non-professional investors behaved as if their investment opportunity is now-or-never, investing if the project is profitable according to a net present value investment rule. Boomsma and Linnerud (Energy, 2015) quantify market and policy risk under different renewable electricity schemes. They compare investors' risk under feed-in tariffs, feed-in premiums and green certificates. They show that green certificates are less risky than commonly believed because part of the market risk is diversified away when you combine two uncertain prices. In fact, the prospect of a termination of the support scheme can represent a higher risk if it is retroactively applied. The way the Norwegian elcertificate scheme is terminated is an example of such policy risk. The political implications of these insights are elaborated on in Samfunnsøkonomen (2016). In June 2012 investors planning 466 hydro power projects in Norway were asked what barriers may prevent their project from being realized under the current elcertificate scheme and how likely it was that their project would be realized. Linnerud and Holden, Energy (2015) analyze these responses using regression analysis. They find that inexperienced investors were more optimistic than experienced investors were, all else being equal. Experienced investors were especially concerned about capacity barriers because of the short duration and abrupt termination of the support scheme in 2020. In addition to the two articles mentioned above, 8 articles have been published or accepted for publication in 2016/2017. The PhD candidate Hagfors contributed to four of these. Fleten was local organizer of the International Conference on Real Options held 15-18 June 2016. We consider this to be an important milestone in the Risky-RES project. Fleten has been interviewed on investment and economics of renewable energy in the popular media (NRK Radio, Aftenposten, Romsdals Budstikke, Ukeavisen Ledelse and Klassekampen.) Linnerud has presented research results from the project during her stay at Oxford University in October and November 2015. In Norway, she has taken part in the public debate on the future of elcertificates, and in February 2016 she organized a seminar on this topic together with Energi Norge. PhD candidate Hagfors presented the status for his research in a midway seminar at NTNU in June 2016. He is expected to successfully complete his PhD graduation as planned in 2017. The final meeting was in Oslo Dec 2016.

The prospects for EU renewable energy and climate policies beyond 2020 are uncertain. Investors and policy makers in Norway and abroad need knowledge on how to make decisions under this uncertainty. Firms' decisions under uncertainty can be formulated as a real option problem in which the option to delay an irreversible decision has a value. Policy as well as market uncertainty will affect the value of the option to wait. The essence of the real options approach is to compare the value of immediate actio n with the expected value of the delayed project. We derive optimal rules for when to invest or operate a plant under uncertain EU policies. This knowledge is used to form better forecasts for investment in and operation of different power plants, and as sess the social welfare cost of different policy designs and uncertain political processes. For Norway, we examine whether it is profitable to invest in reservoir-based flexible balancing power, and whether renewable energy support should be extended beyo nd 2020. We will use three main approaches to examine these questions: 1) analytical solutions to examine general mechanisms relating policy uncertainty to investment risk; 2) simulation techniques to explore more complex and realistic problems; and 3) e mpirical investigation to test whether investors act in accordance with our theoretical models. Modeling policy uncertainty and developing empirically testable models represents two major challenges in the international real options literature. Our proj ect builds directly upon and extends the research in an ongoing Norwegian research project (PURELEC). Thus, the researcher network and methods developed here will be continued. Finally, we have a highly competent research team combining knowledge on fina ncial models with knowledge on climate policy and economics. This research group is extended by actively involving major stakeholders representing the industry and the authorities.