Long-Term Dynamics in CO2 Allowance Prices and Carbon Capture Investments

In this paper we analyse the behaviour of the EU market for CO2 emission allowances; speci…cally, we focus on the contracts maturing in the Kyoto Protocol’s second period of application (2008 to 2012). We calibrate the underlying parameters for the allowance price in the long run and we also calibrate those from the Spanish wholesale electricity market. This information is then used to assess the option to install a carbon capture and storage (CCS) unit in a coal-…red power plant. We use a two-dimensional binomial lattice where costs and pro…ts are valued and the optimal investment time is determined. In other words, we study the trigger allowance prices above which it is optimal to install the capture unit immediately. We further analyse the impact of several variables on the critical prices, among them allowance price volatility and a hypothetical government subsidy. We conclude that, at current permit prices, from a …nancial point of view, immediate installation does not seem justi…ed. This need not be the case, though, if carbon market parameters change dramatically and/or a speci…c policy to promote these units is adopted. Keywords: power plants, European Trading Scheme, Kalman …lter, carbon capture and storage, real options. JEL Codes: