Green Electricity Investments: Environmental Target and the Optimal Subsidy∗

We investigate the optimal investment decision in renewables under market demand uncertainty, in the context of the Italian strategy for renewable deployment under the EU policy. Upon investing, the firm has to decide about the time and size of the investment. We find that a higher subsidy level induces the firm to invest earlier with a smaller investment capacity. This implies that a given environmental target cannot be reached by a too high (too low) subsidy level since this will cause the investment level to be low (too late). We show that there exists an optimal (intermediate) subsidy level to reach the environmental target. Furthermore we find that in a more uncertain economic environment the subsidy adjustment to maintain the target level of investment results in the firm investing earlier, which is opposite to the standard real options result.