Complementing Carbon Prices with Carbon Contracts for Difference in the Presence of Risk - When is it Beneficial and When Not?

Deep decarbonisation requires large-scale irreversible investments throughout the next decade. Policymakers propose Carbon Contracts for Differences (CCfDs) to incentivise such investments in the industry sector. CCfDs are contracts between a regulator and a firm that pay out the difference between a guaranteed strike price and the actual carbon price per abated emissions by an investment. We develop an analytical model to assess the welfare effects of CCfDs and compare it to other carbon pricing regimes. In our model, a regulator can offer CCfDs to risk-averse firms that decide upon irreversible investments into an emission-free technology in the presence of risk. Risk can originate from the environmental damage or the variable costs of the emission-free technology. We find that CCfDs can be beneficial policy instruments, as they hedge firms’ risk, encouraging investments when firms’ risk aversion would otherwise inhibit them. In contrast to mitigating firms’ risk by an early carbon price commitment, CCfDs maintain the regulator’s flexibility to adjust the carbon price if new information reveals. However, as CCfDs hedge the firms’ revenues, they might safeguard production with the emission-free technology, even if it is ex-post inefficient. In this case, regulatory flexibility can be welfare superior to offering a CCfD