Subsidizing energy saving capital accumulation: a real option approach

Some environmental policies, like tax credit, have tried to induce the acquisition of energy efficient units and the replacement of old energy inefficient vintages. However, they have faced the energy paradox that is a slow diffusion of new vintages. We develop a stochastic model of irreversible investment, in which firms also face embodied technological progress. We compare in a dynamic example a deterministic and a stochastic model with embodied technological progress. In the embodied case under uncertainty, the option to postpone replacement becomes very large, reducing drastically the effectiveness of a tax credit.