Valuing investments in the Global Carbon Market Mechanism as compound real options: Lessons from the Clean Development Mechanism

Danny Cassimon*, Peter Jan Engelen, Linda Peters, Martin Prowse

*Corresponding author for this work

Research output: Contribution to journalArticleAcademicpeer-review

Abstract

The Global Carbon Market Mechanism (GCMM) aims to incentivize national or sub-national actors to invest in climate mitigation projects at the same time as limiting the global costs of tackling global warming. Using the worked example of the Clean Development Mechanism (CDM), this article shows that the exact valuation of a mitigation project requires the application of compound real options techniques, as it is able to account for the multi-staged nature of a project cycle, as well as the two basic sources of uncertainty (the probability of not moving successfully to the next stage of the cycle, technical risk, and the uncertainty related to future emission reduction credit prices, market risk). Using parameters from the global database of registered CDM projects, this article illustrates that longer than projected lead times, higher than projected transaction costs, and higher than projected rates of failure lowered the value of investing in CDM projects considerably, alongside offset prices and their variability. Regulators of and participants within the patchwork of existing emission trading schemes and market mechanisms, including the GCMM (Article 6.4 of the Paris Agreement), could benefit through wider appreciation of the benefits of this valuation method.

Original languageEnglish
Pages (from-to)3443-3458
Number of pages16
JournalSustainable Development
Volume31
Issue number5
Early online dateMay 2023
DOIs
Publication statusPublished - Oct 2023

Keywords

  • (compound) real options
  • certified emission reductions (CERs)
  • Clean Development Mechanism
  • Global Carbon Market Mechanism
  • Paris Agreement

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