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A bi-level model for optimal capacity investment and subsidy design under risk aversion and uncertainty

Tsiodra, M. and Chronopoulos, M. ORCID: 0000-0002-3858-2021 (2021). A bi-level model for optimal capacity investment and subsidy design under risk aversion and uncertainty. Journal of the Operational Research Society, doi: 10.1080/01605682.2021.1943021

Abstract

Meeting ambitious sustainability targets motivated by climate change concerns requires the structural transformation of many industries and the careful alignment of firm- and Government-level policymaking. While private firms rely on Government support to achieve timely the necessary green investment intensity, Governments rely on private firms to tackle financial constraints and technology transfer. This interaction is analysed in the real options literature only under risk neutrality, and, consequently, the implications of risk aversion due to the idiosyncratic risk that green technologies entail are overlooked. To analyse how this interaction impacts a firm’s investment policy and a Government’s subsidy design under uncertainty and risk aversion, we develop a real options framework, whereby: (i) we solve the firm’s investment problem assuming an exogenous subsidy; (ii) conditional on the firm’s optimal investment policy, we address the Government’s optimisation objective and derive the optimal subsidy level; (iii) we insert the optimal subsidy level in (i) to derive the firm’s endogenous investment policy. Contrary to existing literature, results indicate that greater risk aversion lowers the amount of installed capacity yet postpones investment. Also, although greater uncertainty raises the optimal subsidy under risk neutrality, the impact of uncertainty is reversed under high levels of risk aversion.

Publication Type: Article
Additional Information: Copyright: 2021 The Author(s). Published by Informa UK Limited, trading as Taylor & Francis Group. This is an Open Access article distributed under the terms of the Creative Commons Attribution-NonCommercial-NoDerivatives License (http://creativecommons.org/ licenses/by-nc-nd/4.0/), which permits non-commercial re-use, distribution, and reproduction in any medium, provided the original work is properly cited, and is not altered, transformed, or built upon in any way.
Publisher Keywords: investment analysis; real options; subsidy design; risk aversion
Subjects: H Social Sciences > HG Finance
Q Science > QA Mathematics
Q Science > QA Mathematics > QA75 Electronic computers. Computer science
T Technology > TD Environmental technology. Sanitary engineering
Departments: Business School > Actuarial Science & Insurance
Date available in CRO: 03 Aug 2021 09:10
Date deposited: 3 August 2021
Date of acceptance: 7 June 2021
Date of first online publication: 8 July 2021
URI: https://openaccess.city.ac.uk/id/eprint/26538
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