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Portfolio risk management and carbon emissions valuation in electric power

Author: Kleindorfer, Paul R. ; Li, LideINSEAD Area: Technology and Operations Management Series: Working Paper ; 2010/05/TOM/ISIC Publisher: Fontainebleau : INSEAD Social Innovation Centre (ISIC) 2010.Language: EnglishDescription: 19 p.Type of document: INSEAD Working Paper Online Access: Click here Abstract: The energy business is in transition from a cost structure based on fuel and capital to a business that also accounts for the carbon footprint of energy production, transmission and end use. In the EU, this is already the case, with a liquid and functioning carbon emissions trading market, and with full subscription to the Kyoto Protocol, including use of additionality offsets from projects certified under the Clean Development Mechanism (CDM) and the Joint Implementation (JI) process. Under the EU’s cap and trade system, and under similar plans envisaged in various bills under discussion in the US Congress, the value of an energy investment will be the joint product of its cash flows (evaluated in the normal fashion) and the implied value/cost of carbon emissions or reductions associated with the investment. Valuation and risk management for energy projects will therefore involve hedging for both energy, inputs and outputs, as well as for carbon outputs. The objective of this paper is to provide an overview of the practicality of extending the normal portfolio problem in electricity supply to encompass the new markets for carbon, and hedging instruments defined on these.
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The energy business is in transition from a cost structure based on fuel and capital to a business that also accounts for the carbon footprint of energy production, transmission and end use. In the EU, this is already the case, with a liquid and functioning carbon emissions trading market, and with full subscription to the Kyoto Protocol, including use of additionality offsets from projects certified under the Clean Development Mechanism (CDM) and the Joint Implementation (JI) process. Under the EU’s cap and trade system, and under similar plans envisaged in various bills under discussion in the US Congress, the value of an energy investment will be the joint product of its cash flows (evaluated in the normal fashion) and the implied value/cost of carbon emissions or reductions associated with the investment. Valuation and risk management for energy projects will therefore involve hedging for both energy, inputs and outputs, as well as for carbon outputs. The objective of this paper is to provide an overview of the practicality of extending the normal portfolio problem in electricity supply to encompass the new markets for carbon, and hedging instruments defined on these.

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