Pollution Reduction, Environmental Uncertainty, and the Irreversibility Effect

This paper analyses the decision to invest to reduce the emissions of a stock pollutant under environmental uncertainty. It shows that this decision depends on the type and level of uncertainty. When uncertainty is small, there is no simple irreversibility effect because of the tension between environmental irreversibility (the stock of pollutant causes costly long-term social damages), and investment irreversibility (pollution abatement investments are sunk). When uncertainty is large enough, however, pollutant emissions should be curbed immediately. A continuous time formulation based on real options illustrates the link between flexibility and option value. These results have implications for global warming. ∗ Participants at the First World Congress of Environmental and Resource Economists in Venice offered useful advice. We thank Mizamur Rahman for his help on special functions. Michael Brennan, Jon Conrad, Joseph Doucet, Peter Kennedy, Bruce Shearer, and Lenos Trigeorgis are gratefully acknowledged for helpful comments on various versions of this paper. Remaining errors are obviously our responsibility.