Business responses to climate policy uncertainty: Theoretical analysis of a twin deferral strategy and the risk-adjusted price of carbon

Climate policies are currently insufficient to meet stabilization goals and remain uncertain. This paper develops a conceptual model to illustrate investment decisions of a risk-neutral firm faced with uncertain climate policy requirements. The firm trades off lost profits from abating too much (being “long”) versus too little (being “short”). Despite risk neutrality, profits are nonlinear such that uncertainty encourages a twin deferral strategy of deferring investment in deploying abatement technology as well as in buying and holding (banking) emissions allowances. This strategy avoids risks of stranded abatement investments but suppresses carbon prices such that prices are projected to evolve through a sequence of stepwise jumps as policies mature. Prices may spike dramatically during an abatement “short squeeze” if firms must rapidly abate in tandem. To mitigate such risk, firms may engineer payoffs from abatement strategies if they have access to suitable hedging tools. These potentially include call options (the right but not obligation to purchase at a fixed price) on avoided emissions from tropical deforestation, as well as investments in R&D and price guarantees (put options) on abatement. Policy makers should support development of hedging tools while enhancing certainty over future policies. [Display omitted] •Uncertain future policy stringency leads firms to defer climate investments.•Uncertainty depresses current carbon prices and leaves firms exposed to future risk.•Carbon prices will tend to rise in a stepwise manner as policies iteratively mature.•Carbon prices may spike in a “short squeeze” if firms must rapidly abate together.•Firms need risk-hedging tools, including from reducing deforestation emissions.