OPTION VALUE OF EMISSION ALLOWANCES

We study the market for emission allowances stipulated in the 1990 Clean Air Act Amendment. We assume that the number of allowances is fixed and that demand is affected by a stochastic parameter that follows a Wiener process ('Brownian motion'). The optimal investment policy for scrubbers is characterized. Investments in scrubbers are reduced if there is greater uncertainty about future market conditions. This is because purchases of emission allowances provide flexibility to adapt to demand conditions in a way that installing scrubbers does not. The price of emission allowances may therefore exceed the marginal cost of scrubbers by an amount called the option value. We derive an explicit formula for the option value and present computational results to illustrate its likely magnitude.