Risk, Embodied Technical Change and Irreversible Investment Decisions in UK Electricity Production: An Optimum Technology Portfolio Approach

UK climate change policy has long been concerned with the transition to a more sustainable energy mix, both environmentally and in terms of energy security. Electricity producers have to handle the uncertainties surrounding investment decisions for new capacity. This chapter focuses on two sources: the volatility of fuel prices and uncertainty concerning technological progress itself in a context of embodied technical change and irreversible investment. Technological uncertainty in combination with high capital costs per MW of installed capacity is likely to deter investors from irreversibly committing resources to the adoption of renewable technologies on a larger scale, even though they have to accept a higher degree of fuel price risk by doing so. Using the extended model, several characteristics of present UK policy are implemented to illustrate the principles involved. The reduction of risk is accompanied by an increase in total costs. For increasing risk aversion, investors are willing to adopt nuclear energy relatively early. Moreover, the embodiment of technical change, in combination with the expectation of a future switch toward another technology, can reduce current investment in that technology. This enables rational but risk-averse investors to maximize productivity gains by waiting for ongoing technical change to materialize until they plan to switch and subsequently invest more heavily in the most recent vintages.