On the option to invest in pollution control under a regime of tradable emissions allowances

This paper analyses the optimal decision of a firm faced with the option of retrofitting its plant to reduce pollution and thereby eliminate the need to purchase emissions allowances. The decision is treated as a real option with the price of pollution permits assumed to follow a known stochastic process. The model is formulated as a set of one-dimensional partial differential equations. At discrete points in time, the firm owner is assumed to make optimal decisions about the retrofitting. In addition, if mothballing is allowed, the owner can halt the installation, with the option of resuming at later date. Optimality conditions are imposed at each decision date, which link the set of one-dimensional partial differential equations. The model is used to calculate critical permit prices at which the firm should choose to retrofit.