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Technology choice and capacity investment under emissions regulation

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We study the impact of emissions cap-and-trade and emissions tax regulation on arm's technology choice and capacity decisions. Our approach differs from existing Operations Management literature, which studies such regulation in deterministic settings. 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 the cap-and-trade regime), and then the firm chooses production quantities. As such, the model reflects a setting where capacities must be developed in the face of signifficant uncertainties, but these uncertainties are largely resolved before production is undertaken, a setting appropriate for power generation and other sectors targeted by emissions regulation (e.g., cement, steel, glass, and pulp and paper). We characterize solutions under both regimes and compare the resulting technology shares, expected profit, expected emissions, and expected production through a numerical experiment grounded within the cement industry. We find that expected profits are greater and expected emissions are less under cap-and-trade, while expected production is greater under an emissions tax, indicating competing welfare effects. Analytical results include unintended consequences and key sensitivities of importance to firms and policy makers that can arise from emissions regulation.

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