The effects of uncertainty under a cap-and-trade policy on afforestation in the United States

To combat climate change, cap-and-trade policies have been proposed and implemented in countries around the world. The stochastic carbon price that results from a cap-and-trade policy makes investment decisions in carbon mitigating and sequestering practices more complex. This letter illustrates the consequence of uncertainty by analyzing forest carbon offset credits under a potential cap-and-trade policy in the United States. The effects of uncertainty on afforestation, carbon sequestration, cropland allocation, and commodity prices using a real option framework are assessed. When compared with deterministic models, less land gets converted from cropland to forestry over the projection period of 40 years because landowners find it optimal to wait before changing land-use to gain more information about the carbon price evolution. The simulation shows that most afforestation occurs in the south and the northeast with almost no conversion in the Corn Belt. The lesson for policy makers is that under carbon price uncertainty, lower afforestation and carbon sequestration takes place. To foster afforestation, mechanisms are necessary to reduce uncertainty at the expense of higher commodity prices. (letter)