Green investment and asset stranding under transition scenario uncertainty

Risks and opportunities related to environmental transition are usually evaluated through the use of scenarios, produced and maintained by international bodies such as the International Energy Agency. This approach assumes perfect knowledge of the scenario by the agent, but in reality, scenario uncertainty is an important obstacle for making optimal investment or divestment decisions. This chapter develops a real-options approach to evaluate assets and potential investment projects under dynamic climate transition scenario uncertainty. It uses off-the-shelf Integrated Assessment Model (IAM) scenarios, assuming that the economic agent acquires the information about the scenario progressively by observing a signal, such as the carbon price or the greenhouse gas emissions. The problem of valuing an investment is formulated as an American option pricing problem, where the optimal exercise time corresponds to the time of entering a potential investment project or the time of selling a potentially stranded asset. To illustrate our approach, this chapter employs representative scenarios from the scenario database of the Network for Greening the Financial System to two energy-related examples: the divestment decision from a coal-fired power plant without Carbon Capture and Storage (CCS) technology and the potential investment into a green coal-fired power plant with CCS. In both cases, the real option value is very sensitive to scenario uncertainty: the value of the coal-fired power plant is reduced by 25% and that of the green coal investment project is reduced by 7% when the agent deduces the scenario by observing carbon emissions, compared to the setting when the true scenario is known. It is also shown that scenario uncertainty can lead to considerable delays in the implementation of green investment projects, emphasizing the importance of timely and precise climate policy information.