Brown Price and Green Firms: An ETS Price Floor for a Clean Transition?

Abstract

We examine the optimal behavior of carbon-emitting companies operating under the European Union Emission Trading System (EU ETS), under which firms are obliged to purchase emission permits on the secondary market if their emissions exceed their allowance. Specifically, we consider the scenario where firms are endowed with the (real) option to undertake a “green” investment to cut their emissions and, thus, permit expenditures. The central challenge is the determination of the optimal time for investment within a stochastic framework characterized by uncertainty in EU ETS permit prices. We address the problem for a heterogeneous group of companies with diverse technological capabilities across industrial sectors. Furthermore, we incorporate a price floor for permit prices to mirror policy efforts aimed at promoting green transition by elevating emission costs. We solve this problem analytically and through numerical simulations calibrated to real market data. In addition to offering insights into individual firm behavior, our findings can support regulators in refining environmental policies, particularly regarding the role of permits price floor and its potential to expedite the green transition.