Technology choice and capacity portfolios under emissions regulation

We study the impact of emissions tax and emissions cap-and-trade regulation on a firm's long-run technology choice and capacity decisions. We study the problem through a two-stage, stochastic model where the firm chooses capacities in two technologies in stage one, demand uncertainty resolves between stages (as does emissions price uncertainty under cap-and-trade), and then the firm chooses production quantities. As such, we bridge the discrete choice capacity literature in Operations Management (OM) with the emissions-related sustainability literature in OM and Economics. Among our results, we show that a firm's expected profits are greater under cap-and-trade than under an emissions tax due to the option value embedded in the firm's production decision, which contradicts popular arguments that the greater uncertainty under cap-and-trade will erode value. We also show that improvements to the emissions intensity of the "dirty" type can increase the emissions intensity of the firm's optimal capacity portfolio. Through a numerical experiment grounded in the cement industry, we find emissions to be less under cap-and-trade, with technology choice driving the vast majority of the difference.