Long Term Investment under Uncertain Carbon Prices

We use a multi-industry general equilibrium model of the New Zealand economy to analyse the macroeconomic implications of an unexpected fall in the carbon price. Previous research has shown that a lower carbon price produces an unambiguous welfare gain over a higher carbon price; there is less deadweight loss from what is effectively a tax, and less of the country’s national income is needed to purchase emission units from other countries.

We are interested in seeing how robust this result is when the reduction in the carbon price is unexpected. Our focus is on events in the electricity generation industry, where strong investment in renewable-based generation under a high carbon price could prove to be inefficient if the carbon price falls.

The results indicate that even at the unexpectedly lower carbon price, using more thermal generation does not raise national economic welfare. This finding is robust to the inefficiency of some capital being stranded in industries that are exposed to a change in the carbon price. There is also a small macroeconomic cost associated with investing in surplus thermal capacity as insurance against lower carbon prices.