Investment decision under uncertainty The case of carbon taxation in developing countries.Investment decision under uncertainty The case of carbon taxation in developing countries.Investment decision under uncertainty The case of carbon taxation in developing countries.Investment decision under uncertainty The case of carbon taxation in developing countries.Investment decision under uncertainty The case of carbon taxation in developing countries.
OVERVIEW OF RESEARCH
Research setting and motivations
Firms face three critical financial decisions: investment, dividend, and financing Among these, the investment decision in foreign countries is particularly challenging due to uncertainties stemming from differing political systems, unfamiliar cultures and laws, and new markets with distinct customer behaviors This complexity has led to significant academic research on "investment decision under uncertainty," a field notably initiated by Hirshleifer.
(1965) in the 1960s Then, it has been developing further by many scholars such as Lucas Jr & Prescott (1971); Abel (1983); Dixit & Pindyck (1994); and Abel & Eberly
(1994, 1997); and currently be a concerned topic in the academic world The reasons behind this development come as follows.
Investing in large fixed asset projects, often referred to as irreversible projects, is expected to yield profitability in the medium to long term, driving significant growth for firms However, such investments come with considerable risks stemming from uncertainties in both internal and external environments External factors include market uncertainties like price fluctuations, market size variations, competitive reactions to large projects, potential technological advancements that could render the firm's technology obsolete, and changes in institutional laws and political stability in the project's intended location.
Uncertainties can significantly raise project investment costs during both the investment and commercial production phases, ultimately increasing production expenses and reducing competitiveness, which in turn lowers profitability Rational investors, aware of these uncertainties, work diligently to quantify and manage them, transforming them into measurable risks By predicting the probability of these risks and their associated costs, firms can incorporate them into financial appraisals, thereby enhancing the likelihood of project success (Munns & Bjeirmi, 1996).
After World War II, Western multinational enterprises experienced significant market expansion, driven by rapid growth in many Western economies This growth enabled large corporations to invest heavily in overseas projects for higher profits, shifting focus from domestic production and exports Consequently, fierce competition emerged among multinational corporations seeking to influence potential investment countries for competitive advantages This investment competition pressured these enterprises to make swift decisions, often in the face of limited information and high uncertainty, necessitating a willingness to accept greater risks associated with their investment choices.
Despite many countries advocating for international economic integration, they often impose trade and investment barriers to protect domestic firms These barriers manifest as technical restrictions, complex regulations, and a lack of transparency in the investment environment Additionally, unclear interpretations of investment policies and local cultural, environmental, and conservation-related restrictions further complicate the landscape Such policies generate significant uncertainty, negatively impacting foreign investment and international trade for foreign enterprises.
The increasing uncertainties and their varying levels pose significant challenges for companies in making investment decisions These challenges have driven the growth of research focused on addressing these issues.
Investment decisions under uncertainty have become increasingly relevant, particularly as multilateral and bilateral trade and investment policies evolve These developments present significant opportunities for firms within member countries To attract foreign investment, host governments must comprehend the behaviors of these firms and formulate suitable policies Vietnam, actively engaging in global economic integration through international trade and investment agreements, is experiencing shifts in its external business environment Consequently, the factors influencing investment decisions are growing in both quantity and complexity, heightening the levels of uncertainty.
Since the United Nations’ Climate Change Declaration in 1992 and the Kyoto Convention in 1997, many countries have committed to reducing greenhouse gas emissions, with carbon taxation being a key strategy While developing nations like Vietnam have not yet adopted mandatory carbon emission reductions, the possibility remains for future implementation Consequently, Vietnam's investment landscape may face uncertainties regarding potential carbon taxes on projects that generate carbon emissions, particularly those reliant on fossil fuels such as coal, oil, and natural gas As highlighted by Yang et al (2008), the risk of carbon taxation is expected to increase post-2012 Given Vietnam's status as a developing country, attracting foreign direct investment remains a priority, especially for large, irreversible projects.
Vietnam is projected to require approximately $608 billion in infrastructure investments from 2016 to 2040, according to forecasts by the Global Infrastructure Hub and Oxford Economics A significant portion of this investment, around $265 billion, is expected to be allocated to large-scale fossil fuel energy projects Such substantial funding necessitates collaboration between local governments and both domestic and international companies Additionally, foreign firms must consider carbon-related uncertainties when making investment decisions, particularly in light of the potential implementation of carbon taxation in the future.
Academic research on investment decisions under uncertainty can be categorized into two primary strands: the first focuses on theoretical frameworks surrounding investment choices amid uncertainty, while the second emphasizes empirical studies examining critical uncertainties, including price volatility, rising costs, exchange rate fluctuations, and tax implications on investment decisions.
Theoretical research by notable authors such as Lucas & Prescott (1971), Hartman (1972), Abel (1983), and Dixit & Pindyck (1994) highlights that an increase in a firm's marginal profit function, in response to heightened uncertainty, incentivizes greater investment and production Pindyck (1991) and Dixit & Pindyck (1994) emphasize the concept of investment irreversibility, noting that investors may delay large-scale asset projects amid rising uncertainty, opting to wait for clearer information to ensure future profitability.
Increased uncertainty can lead to an option value of waiting, suggesting that valuable information may emerge in the future Theoretical research on the interplay between uncertainty and investment identifies two key types of uncertainty: timing uncertainty, which influences the investment point, and uncertainty related to the level of investment itself.
Theoretical research on "investment decisions under uncertainty" indicates that uncertainties related to taxation significantly diminish foreign direct investment (FDI) Pindyck (1986) demonstrated that tax policy uncertainty leads to reduced firm investment levels Similarly, Hassett and Gilbert (1999) confirmed this finding using a randomized continuous-time algorithm Alvarez et al (1998) suggested that investors are likely to accelerate investments if they anticipate a decrease in tax rates, while Hassett and Metcalf (1999) and Agliardi (2001) found that uncertainties in tax policy can delay investment projects.
Theoretical research utilizing simulation methods examines how future uncertainties impact current investment decisions, particularly in irreversible projects Although these uncertainties have yet to materialize, they significantly influence decision-making for investments like coal-fired power plants and iron and steel plants By developing net present value (NPV) models and employing algorithms and computational simulations, researchers analyze potential options affected by future uncertainties, such as carbon taxation.
2013) which are very close research to the thesis.
In Vietnam, there are quite a few researches on the factors affecting FDI inflows in general The typical researches should be referred to Nguyen Thi Lien Hoa
& Bui Bich Phuong (2014); Le Van Thang & Nguyen Luu Bao Doan (2017) Both studies used the quantitative approach to estimate the relationship of factors affecting
Foreign Direct Investment (FDI) inflows into Vietnam are influenced by various factors, including GDP, foreign exchange reserves, infrastructure development, labor costs, trade openness, labor quality, urbanization levels, and the concentration of domestic enterprises Understanding these elements is essential for formulating effective macroeconomic policies aimed at attracting FDI.
Research targets and research questions
This thesis aims to develop a mathematical economic model that analyzes the profit function of firms involved in investment projects, particularly under the uncertainties of carbon taxation By integrating Varian's (1992) profit function with the unpredictable impacts of carbon taxes, the model illustrates how these factors influence investment decisions Following the model's construction, an optimization algorithm will be employed to explore the interactions between carbon tax variables and key elements of the profit function, including capital stock (K) and labor level (L) The findings will be interpreted to propose relevant theoretical insights.
This thesis aims to identify research gaps by reviewing both theoretical and empirical studies, with a primary focus on developing a mathematical model to address these gaps It will specifically analyze how uncertainties related to carbon taxation impact the investment decisions of investors from developed countries, particularly those subject to carbon taxes, as they invest in irreversible projects in developing nations similar to Vietnam, which do not have such taxes By creating mathematical models and conducting calculations, the research will evaluate investment decision-making and the selection of capital, technology, and labor levels in irreversible foreign direct investment (FDI) projects in Vietnam amidst carbon tax-related uncertainties.
In order to fulfill the research objectives of the thesis, the following two research questions were studied and answered by the thesis.
(1) How are effects of carbon taxation uncertainties on investors’ investment decision in irreversible FDI projects?
(2) What are the capital / technology and labor levels selected by the investors in irreversible FDI projects?
Research objectives and scope of research
This thesis focuses on how foreign firms make investment decisions regarding irreversible projects amidst uncertainties related to carbon taxation, which is increasingly being implemented in developed countries to promote sustainable development and is expected to be adopted in Vietnam soon The study will analyze the effects of these carbon tax uncertainties on the investment behaviors of foreign investors, particularly concerning their optimal choices of capital, technology, and labor in their projects in Vietnam.
To enhance foreign direct investment (FDI) projects while reducing environmental impacts, it is essential to implement strategic managerial and policy recommendations These strategies should focus on attracting high-quality FDI that not only minimizes ecological harm but also elevates the standards of technology and labor involved in these initiatives.
This research focuses on the substantial fixed assets of foreign companies in Vietnam that contribute to carbon emissions, highlighting the associated risks of uncertainty and potential carbon taxes for these projects Referred to as irreversible investment projects by McDonald & Siegel (1986), these high-value initiatives encompass essential sectors such as transportation, telecommunications, energy, and real estate Typically, they involve multinational enterprises (MNEs/MNCs) from developed nations Given the trend of carbon tax avoidance from developed countries to developing nations without such taxation, the findings of this study in Vietnam can be applicable to other developing countries facing similar challenges.
Methodology
The thesis employs a quantitative approach through mathematical modeling and simulation techniques, utilizing both reasonable assumptions and available practical data The selection of the research method is based on the nature of the study, relevant literature, and the accessibility of actual data.
This thesis investigates a novel research area focused on investment decisions under uncertainty related to future carbon taxation in Vietnam, where similar studies are currently lacking Utilizing qualitative methods, such as in-depth interviews with experts, may reveal significant biases due to the absence of existing carbon tax-related uncertainties, making discussions about future implications challenging Consequently, the findings may reflect these biases in the collected data.
Relying on interviews for information about MNEs/MNCs is not a reliable approach for analysis Additionally, using quantitative research to collect empirical data for hypothesis testing is impractical, as carbon taxation has not yet been implemented, meaning that the data will not accurately represent the effects of carbon tax uncertainty Therefore, employing empirical quantitative methods is not a feasible option.
This thesis utilizes quantitative methods through algorithmic modeling and computational simulations to analyze the impact of carbon taxation uncertainties on a firm's profit function By employing mathematical techniques, the study aims to assess how these uncertainties influence investment decisions regarding capital, technology, and labor levels within the firm.
The profit function model proposed by Varian (1992) is favored over the traditional net present value (NPV) approach due to its distinct advantages According to Varian (1992, p 23), this model offers a comprehensive framework for analyzing a firm's profitability.
- � : is profit function of the firm.
- F (K, L): is the production volume of the firm depending on capital level (K) and labor level (L).
- C (r, w): is the cost of the business operation depending on the cost of capital (r) and labor wage (w), not including the cost of carbon tax.
- T (τ): is the cost of carbon tax that the firm needs to pay when the government imposes carbon tax on the volume of carbon emission.
- p is average selling price of products
The function operates under the fundamental assumption that the firm consistently invests when the return is greater than zero, aiming to maximize profits as a rational investor Consequently, the firm selects optimal input levels for capital (K), labor (L), rental rate (r), and wage rate (w) to achieve profit maximization A comprehensive discussion of the research methodology and model selection is provided in Chapter 3 of the thesis.
Expected outcomes of the thesis
The thesis aims to enhance academic knowledge and research methods in project appraisal, particularly focusing on the uncertainties surrounding investment decisions in irreversible projects, with an emphasis on carbon taxation in Chapter 2 It will establish a theoretical framework supported by empirical evidence, revealing that carbon taxation may restrict low-tech investors Furthermore, the development of mathematical models within the thesis is anticipated to yield new theoretical insights, suggesting that the government could leverage carbon tax as a policy tool to elevate the quality of foreign direct investment (FDI) projects This novel theoretical contribution underscores the significance of the thesis in the field.
The thesis introduces innovative research methods and tools, including mathematical modeling and simulation techniques, which are relatively new to Vietnam's academic community This approach enhances the diversity of research tools available in Vietnam's research practices.
This thesis examines various project appraisal methods, specifically Discounted Cash Flow (DCF) and Return on Investment (RO), for large asset projects that significantly impact industrial growth and national economic development It serves as a valuable reference for applied research on investment project appraisal and enhances knowledge in project finance, appraisal, and management, making it a useful resource for student training.
Structure of the thesis
The thesis is structured into five chapters, with Chapter 1 offering a comprehensive overview of the research This chapter covers essential elements, including the research context, motivation, objectives, and scope, as well as the anticipated academic contributions and practical applications of the study.
Chapter 2 - Theoretical framework and empirical evidence, focusing on the analysis of previously theoretical researches in the world and developing the framework related to the main research direction of the thesis is the relationship between the firm’s investment decision and uncertainties in the irreversible project A number of relevant empirical studies will also be analyzed and commented to identify research gaps The final part of Chapter 2 is to analyze and select the basic research model which is the profit function of firm for further modeling and simulation of the thesis.
Chapter 3 - Research Method is to focus on comparative analysis for selection of research method on the given research settings, research targets, research questions, objectives and scope of research Chapter 3 also discusses the basic assumptions in the research model and simulation data to ensure both the convenient development of the model, but such the assumptions do not distort the research results.
Chapter 4 - Research results is to focus on the development of investment decision model of the firm to invest in the investment project in different cases such as
The implementation of a carbon tax can vary, with expectations of its application throughout the project life cycle This affects the investment decision-making processes of two distinct firms as they choose their capital, technology, and labor levels under the same carbon tax rate The theoretical insights from these scenarios will provide a foundation for subsequent simulation studies.
Chapter 5 - Conclusions and managerial/policy implications are developed on the basis of research results in Chapter 4 This chapter will summarize and interpret the results of theoretical findings Based on these findings, a number of policies and managerial implications are proposed Chapter 5 will also discuss some further research directions to better deepen the researches on the relationship between carbon taxes and the firm’s investment decision.
THEORETICAL FRAMEWORK AND EMPIRICAL
The firm and investment operation
2.1.1 The rationality of the firm’s investment decision.
A firm is defined as a legal entity created for the purpose of generating profit, as established by law (Chandler, 1992) Its activities are strategically designed to achieve profits in the short, medium, and long term Initially, firms primarily focused on trading goods, which encompassed buying, storing, sorting, processing, packaging, and transporting products.
The evolution of firms from artisanal to industrial production has led to the integration of machinery and equipment as essential components of business operations This shift marks the transition into an era focused on service and industrial production According to the author, the development of a firm hinges on three key factors: continuous learning and experience of managers and employees, the advancement of production equipment and technology, and the availability of capital.
The East India Company, established in 1600, is recognized as the world's first multinational company, pioneering the model of multinational enterprises by purchasing, transporting, and selling agricultural products while exploiting colonial resources Its operations included investing in agriculture within colonies, with the intent of importing goods back to the United Kingdom (Sen, 1998).
The modern industrial enterprise, which began to take shape in the 1880s, is defined by the integration of highly educated labor and advanced machinery, leading to capital-intensive production This combination enables businesses to optimize production inputs, resulting in economies of scale where increasing output reduces the per-unit cost.
Industrial enterprises predominantly operate in sectors that require advanced technology and equipment, including automobile assembly, transportation, energy, oil and gas, chemicals, and pharmaceuticals Recently, a new wave of industrial companies has emerged, focusing on digital services and information-communication technology, with notable examples being Intel, Google, Microsoft, Apple, and Samsung Many firms within the S&P 500 are classified as large industrial or technology enterprises, with their investments typically directed towards large-scale projects that involve substantial capital, complex technology, and a demand for highly skilled labor, ultimately producing and supplying high-tech products and services.
The firm not only serves as a producer and supplier of goods but also functions as an investor, continuously seeking opportunities to invest This strategy helps the company maintain its established market position while also exploring new potential markets.
In 2015, industrial enterprises increasingly prioritized the identification, assessment, and decision-making processes related to significant industrial projects, recognizing these large-scale initiatives as strategic investments essential for their growth and competitiveness in the modern industrial landscape.
The general profit function of an enterprise is denoted as Л calculated as turnover minus production cost.
To maximize profit, a firm determines the optimal production level (q) where its profit (Л) reaches its highest value at a given average selling price (p) The cost of production (C) increases proportionally with production volume, meaning that as production rises, so do costs Therefore, the firm strategically selects the output level that maximizes its profitability.
The output of a firm can be represented by a Cobb-Douglas production function, expressed as q = AK^α L^β, where q denotes output, K represents capital or technology, and L signifies labor This function illustrates the relationship between a firm's profit and its inputs of capital and labor Furthermore, the profit function can be expanded to incorporate additional production costs, such as future operational expenses like new taxes.
Modern businesses, including large family-owned enterprises, are often overseen by a team of closely governed managers who adhere to strict internal governance policies These policies are designed to ensure that all business operations focus on maximizing profits or increasing dividends for shareholders, with board members committed to these objectives.
Internal governance policies can be adjusted to align with the current production and business environment, aiming to optimize profits Consequently, firms act as rational investors, making decisions grounded in reliable information, solid evidence, and sound reasoning, while minimizing emotional influences (Carlton & Perloff, 2015).
Rational investors prioritize target profits as the key criterion in their investment decisions, focusing primarily on expected financial returns In contrast, social investors and social enterprises often opt for projects that, while potentially yielding lower financial gains, offer significant social impact This highlights a fundamental difference in investment philosophy, where the former emphasizes financial returns and the latter values social contributions alongside financial considerations.
To maximize profits and thrive in a competitive landscape, firms must adopt effective governance practices, reduce operational costs, and actively seek new customers while expanding their market presence Additionally, ongoing research and strategic investment in promising new projects are essential for achieving medium- to long-term profitability.
Investment involves reallocating capital from a low-risk state to a higher-risk state to achieve greater future profits However, investments are inherently subject to market uncertainty and potential risks, with the exception of low-risk options like government bonds from stable economies, which are viewed as non-risk portfolios (Barry, 1980).
Investment, as defined by Reilly & Brown (2002), encompasses three key characteristics: a commitment to allocate capital over a specified timeframe, exposure to inflation, and susceptibility to uncertainty or risk regarding future returns Investment activities include purchasing and holding materials, commodities, stocks, bonds, financing struggling companies, lending, and injecting capital into new projects From an economic standpoint, under conditions of perfect competition, firms are likely to increase production and expand investments when the selling price exceeds the average production cost in the long run (Marshall, 1987; Dixit, 1992) Consequently, businesses are inclined to invest when they anticipate significant profits in the medium to long term.
Foreign direct investment and its impact factors
Since the end of World War II, large corporations in Western countries have increasingly turned to foreign direct investment (FDI) as a key driver of economic growth globally (UNCTAD, 2004) The study of FDI gained momentum in the 1960s and 1970s, with scholars like Hymer (1960) and Caves (1971) highlighting its role in leveraging firms' fixed asset advantages in international markets FDI enables companies to secure easier access to raw materials, reduce reliance on imports, and optimize production processes by utilizing specialized labor and facilities across borders, ultimately achieving economies of scale For instance, firms can conduct preliminary processing in foreign countries and import the refined products for final completion Additionally, FDI can help companies circumvent trade barriers and lower transportation costs Dunning (1971) posited that FDI serves as a strategic defense mechanism for firms, allowing them to diversify and mitigate risks associated with over-reliance on their home markets, while Watters (1995) noted that FDI projects can alleviate constraints posed by saturated domestic markets.
Foreign direct investment (FDI) encompasses various methods such as establishing representative offices, engaging in business cooperation contracts, acquiring shares in local companies, and launching new projects or wholly-owned enterprises Defined as the establishment of a business in a foreign country by a foreign entity, FDI can involve full ownership or joint ventures with local partners According to UNCTAD, a firm is classified as an FDI if foreign ownership exceeds 10% of voting capital The benefits of FDI for foreign investors include access to low-cost local resources, insights into domestic market behaviors, and the ability to create diversified production networks across countries, optimizing costs and benefits However, investing in developing countries poses risks such as political instability, inadequate legal frameworks, and fluctuating tax systems.
Foreign Direct Investment (FDI) research can be categorized into two primary areas: the examination of its benefits and a critical assessment of its limitations Key concerns include the over-exploitation of local resources, leading to unsustainable development that adversely impacts the natural environment and landscapes of host countries Additionally, many FDI projects utilize outdated technologies and refurbished equipment, resulting in significant waste and pollution (Harrison, 1994).
Foreign Direct Investment (FDI) offers several significant benefits to host countries, including increased wages and employment opportunities (UNCTAD, 2004), enhanced utilization of local raw materials and inputs, which fosters domestic investment and production, and positive spillover effects to local firms (Javorcik et al., 2007; Kneller & Pisu, 2007) Additionally, FDI facilitates technology transfer to domestic companies, boosting productivity (Kokko et al., 1996; Gorg & Strobl, 2001; UNCTAD, 2004; Potterie & Lichtenberg, 2001), contributes to higher export levels and foreign currency inflows (Nigel Pain & Katharine Wakelin, 2002), and aids in transitioning the manufacturing sector towards greater industrialization (Dunning & Narula, 2003).
The study of factors influencing Foreign Direct Investment (FDI) flows into a country has been a significant area of research since the 1970s, focusing on national, sectorial, and firm-level influences These factors can be categorized into three main groups: firm characteristics, investment project attributes, and external factors, including exchange rates, tax policies, institutional quality, host country location, and trade protection Root and Ahmed (1978) further classified these influences into four categories: economic indicators like GDP and infrastructure development; social factors such as human resource quality and urbanization; political aspects including government stability and administrative performance; and government policies related to FDI taxes and regulations This thesis particularly examines the uncertainties surrounding taxation in the context of FDI.
Tax uncertainty significantly affects project profitability, as investors seek clarity on statutory tax liabilities and potential future tax rate increases, including environmental and carbon emissions taxes Research by Root & Ahmed (1978) indicates that rising corporate tax rates deter Foreign Direct Investment (FDI), while Swenson (1994) found that FDI increased after the US reformed its FDI-related taxation in 1986 Additionally, Bellak & Leibreacht (2009) highlighted that corporate income tax reductions positively influenced FDI inflows in Central and Eastern Europe from 1995 to 2003 Overall, these studies demonstrate that the tax rates and policies of FDI host countries significantly impact FDI inflows, making investors cautious about tax-related uncertainties when considering investment opportunities.
Irreversible project
Foreign Direct Investment (FDI) plays a crucial role in funding large, irreversible projects that are essential for a robust economy These projects, often requiring significant capital and extensive preparation, typically demand around 10% of the total investment for activities such as market research and feasibility studies According to Archibald & Voropaev (2004), irreversible projects include transport and telecommunications infrastructure, energy infrastructure like refineries and power plants, and the production of essential commodities such as steel and chemicals Such projects are vital for economic strength, particularly in developing countries like Vietnam, which prioritize investment in large fixed asset projects to drive growth and development.
New weapon system; major system upgrade Satellite development/launch; space station mod Task force invasion
Acquire and integrate competing company Major improvement in project management Form and launch new company.
Consolidate divisions and downsize company Major litigation case.
Microwave communications network. 3rd generation wireless communication system.
2004 Summer Olympics; 2006 World Cup Match.
Closure of nuclear power station.Demolition of high rise building.
5.4 Facility, design, procurement, construction in Civil, Energy,
Process plant maintenance turnaround. Conversion of plant for new products/markets.
Flood control dam; highway interchange.
New gas-fired power generation plant; pipeline Chemical waste cleanup.
New shopping center; office building. New housing sub-division.
New tanker, container, or passenger ship
6 Information Systems (Software) Projects New project management information system (Information system hardware is considered to be in the product development category.)
7.7 Infrastructure: energy (oil, gas, coal, power generation and distribution),
People and process intensive projects in developing countries funded by The World Bank, regional development banks, US AID, UNIDO, other UN, and government agencies; and
Capital-intensive civil works projects differ from facility projects by encompassing various sectors such as industrial, telecommunications, transportation, urbanization, water supply, sewage, and irrigation These projects typically involve establishing an organizational entity responsible for operating and maintaining the facility Additionally, lending agencies enforce specific project lifecycle and reporting requirements.
8.2 Live play or music event
New motion picture (film or digital) New TV episode New opera premiere
New automobile, new food product. New cholesterol-lowering drug.
New life insurance/annuity offering.
Measure changes in the ozone layer How to reduce pollutant emission. Determine best crop for sub-Sahara Africa Test new treatment for breast cancer.
Determine the possibility of life on Mars
An important characteristic associated with the investment decision in the large asset project is the project’s irreversibility which was first mentioned in 1986 by
McDonald and Siegel (1986) initiated a research focus on investment decisions in large-scale projects, further explored by Bertola (1998) Pindyck (1990) emphasized that significant investments, such as in refineries, power plants, and chemical facilities, involve multiple design stages and substantial preparation costs These large asset projects typically exhibit two key characteristics: first, irreversibility, where any cancellation during the investment phase results in sunk costs, as the expenditures cannot be repurposed; second, the possibility of pausing these projects to await more favorable conditions, such as increased product prices, reduced initial costs, or improved policies, enabling investors to make informed decisions.
Irreversible investment projects, such as high-value production initiatives, infrastructure developments, power plants, and oil refineries, typically have extensive life cycles ranging from 20 to 30 years or more These projects share common characteristics, including their prolonged duration and significant capital commitment.
Investment projects often require substantial initial capital and extensive preparation time, including design, equipment procurement, and construction The decision-making process for these investments can be lengthy and fraught with uncertainties, necessitating careful consideration of various factors Typically, these projects unfold in multiple phases, as illustrated in the accompanying diagram.
Diagram 2.1: Typical Project Life Cycle (Burke, 2003)
Phase 1, known as the Concept or Initial Phase, involves essential preliminary investment preparation and research During this stage, the project is thoroughly evaluated to determine its alignment with the firm's strategic goals Various analyses are conducted, typically documented in a pre-feasibility study (Pre-F/S), which aids in decision-making regarding whether the project should advance to the next stage, the detailed feasibility study (Detailed F/S).
Phase 2, known as the Intermediate/Development stage, is crucial for investment preparation, primarily reflected in the feasibility study During this phase, inputs for project evaluation are quantified with precision, and financial analyses, including key indicators such as NPV, IRR, and B/C, are calculated as accurately as possible The investment decision is made once the feasibility study is complete and the total project investment cost is determined based on reasonable assumptions However, uncertainties may arise during this decision-making period, prompting cautious investors to pause their investment until more favorable information is available or uncertainty levels decrease.
Cost & Human efforts for project
The "wait and see" approach refers to the temporary suspension of project investment decisions while awaiting clearer information, as discussed by Bjerksund & Ekern (1990) and Stokey (2016) This strategy is particularly relevant for firms considering irreversible projects, where the implications of investment choices are significant and long-lasting.
Strategic financial decisions, such as project investment preparation, play a crucial role in enhancing corporate value and stock prices Early investment in project development, coupled with effective public relations, can significantly increase the market value of a project This approach not only minimizes initial costs but also contributes to overall firm value, as highlighted by Pindyck (1994) and Fuss & Vermeulen (2008).
In Phase 3 (Intermediate - Execution), investors begin to incur substantial costs related to detailed design, consulting services, advance payments to equipment suppliers and contractors, and construction expenses At this stage, the project becomes largely irreversible; if investors decide to cancel, they face significant financial losses due to the high total expenditures, which are now classified as sunk costs.
Phase 4, the final stage of the project, involves transitioning from the execution phase to a period of trial and commercial operation During this phase, the focus shifts to producing and selling the product or service in the market.
By the end of the second phase, investors typically allocate 5-10% of the total project cost to market surveys, research, project design, and feasibility studies (Burke, 2003) If a project is canceled, this investment is entirely lost, as the feasibility study cannot be repurposed for another project During this phase, if significant uncertainties arise, investors often adopt a "wait-and-see" approach, pausing their decision-making until more favorable information is available.
CASE STUDY OF IRREVERSIBLE AND REVERSIBLE PROJECTS
Despite a thorough review of existing literature, the author found no empirical studies that quantitatively differentiate between two types of projects based on capital or labor scale Currently, the primary distinction lies in the size of the sunk costs incurred by investors, which cannot be recovered if they decide to abandon the project Higher sunk costs indicate greater irreversibility, while lower costs suggest more flexibility Numerous real-world examples illustrate the concepts of irreversible and reversible projects, influencing investment decisions in various scenarios.
The Nghi Son refinery and petrochemical project, a significant irreversible investment, involves a collaboration between the Vietnam Oil and Gas Group (PVN), Idemitsu Group, Mitsui Chemical, and Kuwait National Oil and Gas Group With a total investment of approximately $9 billion, this project received approval from the Vietnamese government and was included in the master plan since 2003 Following the approval, investors dedicated five years to conducting detailed feasibility studies, technical designs, and cost estimates before making the final investment decision in 2008, resulting in sunk costs amounting to several hundred million USD.
By 2008, investors received investment licenses and were allowed a capital construction investment period exceeding 10 years In cases where uncertainties arise during the project preparation phase or are anticipated during the 40-year operational period, investors often opt for a "wait and see" approach This strategy allows them to clarify uncertainties, reassess risks, and recalibrate financial projections, ultimately enhancing their chances of recovering substantial sunk costs if the project becomes commercially viable In the case of the Nghi Son Refinery and Petrochemical Project, investors demonstrated the need for compensation on import taxes at the factory gate price to ensure competitiveness against imported products from companies like Petrolimex This significant uncertainty prompted investors to seek government guarantees, effectively transforming the uncertainty into a manageable risk and improving the project's overall feasibility.
Reversible project : Also in this big project, Nghi Son Refinery and
Investment decision under uncertainties
According to McMenamin (2002), investment decisions can be categorized into tactical and strategic types Tactical investment decisions involve a firm's quick investments in financial instruments like stocks, bonds, and intangible assets such as intellectual property, patents, copyrights, and trademarks These decisions are often influenced by current market conditions, particularly the state of the stock and financial markets, allowing firms to either hold these highly liquid assets for the long term or sell them swiftly.
Strategic investment decisions involve firms committing to large, irreversible projects that are crucial for maintaining their market position over the medium to long term These capital-intensive projects are expected to enhance the firm's value and ensure long-term development, as highlighted by Al-Ajmi et al (2011) However, such irreversible investments often encounter significant uncertainties that can impact expected returns, prompting extensive research by various authors into how firms navigate investment decisions under uncertain conditions.
Lucas (1971) pioneered the mathematical modeling of firm value (V), which is influenced by factors such as product price (p), production output (q), investment level (x), and discount rate (β) over time (t), under the assumption that firms strive to maximize their value Abel (1983) further explored the impact of price volatility on neutral risk investors' investment levels, utilizing a Cobb-Douglas production function that incorporates capital stock (K) and labor (L) as primary inputs alongside the price factor His findings aligned with Hartman (1972), indicating that an increase in selling price raises the marginal value of capital, prompting firms to invest more Additionally, Abel & Eberly (1994) enhanced the firm value model (V) by considering the expected total operating profit (π) minus total operating costs throughout the project lifecycle, accounting for the uncertainty of the shadow price (q) of installed capital.
Eberly (1994) found that firms aim to maximize their value (V) by optimizing two key inputs: capital stock (K) and technology (ɛ), which are essential for their production processes.
Caballero (1991) summarizes the researches of Hartman's (1972) study, Abel
The relationship between uncertainties and investment in building a firm's value model has been explored in various studies from 1983 to 1985, focusing on profit, capital, and labor within perfect and imperfect competition markets Caballero (1991) found that adjusted investment costs due to information asymmetry do not significantly impact this relationship; instead, the cost of investment capital and marginal profits from increased investment are crucial factors Dixit and Pindyck (1994) utilized a net present value (NPV) formula to analyze how product price, interest rates, and construction costs affect NPV and, consequently, firm value While their findings are illustrative, they lack generalizability due to the specific formulation of NPV Recent research by Stonkey (2016) introduced a theoretical model addressing firm investment decisions amid tax policy uncertainty, demonstrating that firms may choose to delay investment projects and adopt a "wait & see" approach.
Research, with the exception of Dixit & Pindyck (1994), typically shares key characteristics: (1) Authors focus on firm value (V), incorporating profit functions (π) based on gross or operating profit, which rely on critical inputs such as capital stock (K) and labor (L) These models also account for uncertainties like product selling prices and capital costs, under the assumption that firms aim to maximize their value or project profitability; (2) The profit function is generally represented in a Cobb-Douglas form, emphasizing the two primary inputs of capital stock (K) and labor (L).
Research on investment decisions under uncertainty has focused on irreversible projects like steel plants, coal-fired power plants, and real estate developments, which are significantly influenced by government policies For instance, a coal-fired power plant's revenue can be drastically affected by the implementation of carbon taxation Studies by Sekar (2005), Reedman et al (2006), Herbelot (1992), Titman (1985), and Wang & Zhou (2006) have utilized the Real Options Approach (ROA) to address these uncertainties The project's expected profitability is impacted by these uncertainties, making the choice of project appraisal method critical; the ROA has proven effective in adapting to potential future changes.
In a 2005 case study on project appraisal for a coal-fired power plant, researchers examined two technologies with varying carbon emission levels, resulting in different environmental costs and carbon taxation implications The study highlighted that uncertainties related to carbon taxation significantly influence the project's operating costs, suggesting that the Net Present Value (NPV) may have underestimated input costs compared to Return on Assets (ROA).
Empirical research on the effects of uncertainty on firm investment decisions at the sector level reveals diverse findings Studies have examined the influence of inflation and US sales price fluctuations on firm investment from 1954 to 1989 (Huizinga, 1993), as well as the effects of price volatility on current and future investments in US manufacturing firms (Ghosal & Loungani, 1996) Additionally, research has highlighted the relationship between price fluctuations, product demand, and business investment (Peters, 2001), stock market volatility's impact on investments in developed economies (Lensink, 2002), and how exchange rate fluctuations can affect investment decisions (Byrne & Davis, 2005).
An analysis of theoretical and empirical studies on "investment decision under uncertainty" reveals significant diversity in research approaches Theoretical frameworks establish a firm's value function (V) as the profit function minus costs, incorporating uncertainty-related expenses The profit function is typically modeled as a Cobb-Douglas function with inputs of capital (K) and labor (L) Key contributions from researchers such as Abel (1983), Caballero (1991), Pindyck (1990), and Abel & Eberly (1994, 1998) have advanced this theoretical model These studies emphasize uncertainty factors including product selling prices, capital investment costs in competitive markets, and issues related to asymmetric information A fundamental assumption underlying this research is that firms consistently aim to maximize profits and enhance business value.
Table 2.4 provides a summary of key publications that underpin the foundational principles of this thesis, including the model structure, primary variables, and assumptions from these sources, which will be utilized to construct and enhance the research model presented in this study.
Table 2.4: Summary of related theoretical/empirical studies on investment decisions under uncertainties.
Authors Model & forms of function
Lucas (1971) Value of the firm
(V) Cobb-Douglas production function with K and L are two main variables
Product price (p), production volume (q), investment level (x), discount rate (β), according to time (t)
(1)Firm always maximize their profit;
(2) production function is constant returns to scale.
Abel (1983) Cobb-Douglas production function
Captial stock (K) and labor level (L), price fluctuation,
(1) Firm always maximize their profit;
(2) Competitive market, risk neutral firm;
Value of firm (V) in perfect competition and imperfect competition market.
Profit function ( � ) capital stock (K); labor level (L), cost of capital and other cost
(1) Perfect and imperfect competition market; (2) Constant economy of scale; (3) Risk neutral firm
Value of firm (V) is the sum of expected present value of operating profit ( � )
Shadow priec (q) of installed capital
Firm always maximize their firm value by solving the optimization of firm minus the sum of operational cost.
Product price (p); technology (ɛ); value (V) according to (K) and (L) as main variable.
Sekar (2005) Case study of project appraisal for caol fired power project with different technology.
NPV/RO in explicit form (numerical function in stead of variable function.
Explicit number of initial investment capital, carbon emission volumeand cost of carbon taxes.
Author using explicit data to calculate and compare three investmet plans, using the basic assumption as of NPV.
Investment decisions under carbon taxation uncertainties
2.5.1 Carbon taxes and carbon leakages
The Earth's rising temperature is primarily caused by the accumulation of greenhouse gas emissions, particularly carbon dioxide, in the ozone layer, leading to global climate change Carbon emissions largely stem from electricity production using fossil fuels like coal, oil, and gas, as well as human activities such as transportation and agriculture In response to this crisis, the Kyoto Protocol, established in 1997, saw many countries commit to reducing carbon emissions By 2011, 36 developed countries, including 29 European nations counted as one, were part of the Annex I group, while 137 developing countries agreed to future emission reductions without specific commitments The Annex I countries have implemented various measures to lower emissions, including emission quotas, carbon taxes, and promoting renewable energy sources.
Carbon taxes are implemented to hold producers accountable for their carbon emissions, typically based on the amount of carbon released or the electricity generation capacity of fossil fuel-based power plants By increasing production costs, these taxes incentivize high-emission producers to adopt greener technologies, often referred to as green investments Research, including studies by Speck (1999) and others, has shown that carbon taxation effectively reduces corporate emissions and encourages technological advancements that lower carbon output Carbon taxes can be applied at various stages of the production chain, targeting either direct carbon emitters or suppliers of carbon-intensive materials, a strategy known as vertical targeting For instance, a coal producer may be taxed upstream, while a coal-fired power plant, which directly emits carbon, may face taxation as well, ultimately impacting electricity consumers through increased prices.
According to Bushnell & Mansur (2011), direct carbon taxation on firms, particularly coal-fired power plants, can lead to "carbon leakage," where investors shift their capital to non-carbon taxed countries to evade taxes (Babiker, 2005) This phenomenon encourages foreign investment in high-emission sectors, such as steel and electricity, in developing nations that lack carbon taxes Research suggests that imposing carbon taxes on upstream manufacturing processes is more effective than taxing downstream products, as downstream taxation increases the risk of investment migration to non-taxed regions For instance, applying carbon taxes on coal rather than on power plants may better mitigate carbon leakage Additionally, implementing other carbon-related measures, such as border adjustment taxes, export carbon taxes, or carbon trading mechanisms, could further reduce carbon leakage (Bushnell et al., 2011).
In response to the carbon taxation policies in a country, the producers in carbon- taxed country will have several options as follow.
(1) Firms who have to pay carbon taxes may decide to invest in greener (less carbon emissions) technologies in comparison with the currently being used
Carbon leakage occurs when production shifts from countries with carbon taxes to those without, leading to increased total carbon emissions due to the transportation of imported goods (Wei et al., 2016) Investing in greener technology requires significant initial capital, resulting in higher costs for eco-friendly products compared to those made with traditional methods Consequently, products manufactured using green technology may struggle to compete on price, and the transition to such technology can be a lengthy process.
2) The firm will retain the old technology but they will separate the production segment: they can hire other firms in a non-carbon taxed countries to produce a heavily carbon emission parts of products and then import that components back to the mainland to assemble the finished product (Wei et al, 2016) In this case, the decision can be made and executed faster than the case (1) Therefore, in the short and medium term, the firm can use this solution to reduce production costs However, they also need to restructure their production assembly in their carbon-taxed country to match the order-making operations in other non-carbon taxed countries In addition, it is more difficult for the firm to control production quality abroad.
To enhance competitiveness and mitigate carbon taxation impacts, firms may strategically relocate their production equipment to non-carbon taxed countries, as noted by Branger & Quirion (2014) Alternatively, they might invest in new projects while retaining older, high-emission technologies, leading to carbon leakage through the import of non-carbon taxed products back into carbon-taxed nations This practice ultimately increases overall carbon emissions due to transportation distances, undermining the goals of carbon taxation Developing countries, such as Vietnam, attract investors with lower input costs and lack of carbon taxes, making them appealing for investment aimed at avoiding carbon taxation Since the Kyoto Protocol in 1997, the trend of investing in non-carbon taxed regions has been on the rise.
Since the 1990s, a significant drop in global freight rates has led to increased investments aimed at avoiding carbon taxes A study by Peters et al (2011) reveals that from 1992 to 2008, carbon emissions in developing countries have doubled, while emissions from developed nations remained relatively stable During this period, imports from developing countries to developed nations nearly doubled, highlighting a complex relationship between trade and carbon emissions.
Developed countries contribute to increased carbon emissions indirectly through higher consumption levels According to Peters et al (2009), international trade facilitates the transfer of carbon emissions from countries with carbon taxes, specifically those in Annex I of the Kyoto Protocol (1997), to non-carbon taxed nations not included in Annex I.
Numerous empirical studies indicate that the value of carbon leakage-related investments varies across different industries Paltsev's research highlights the geographical and sectoral differences in carbon leakage-related investment within the region.
Research on carbon leakage related investment has shown significant variability in estimated values, with findings ranging from 5% to 130% Notably, Babiker (2005) attributed the higher estimate of 130% to the displacement of energy-intensive production subject to carbon taxation, while other studies, often using similar methodologies, reported lower rates Babiker's use of a comprehensive computational model, incorporating multiple variables, contributed to these differing results Additionally, Elliott et al (2010) estimated the carbon leakage rate for countries in Annex B of the Kyoto Agreement to be around 20%.
Carbon leakage rates remain uncertain, as noted by several authors (Barker et al., 2007; Harstad, 2010) Nevertheless, empirical studies generally indicate a significant increase in carbon leakage-related investments, shifting from countries with carbon taxes to developing nations that lack such taxes.
Investing in non-carbon taxed countries to evade carbon taxation involves navigating several uncertainties, particularly regarding the timing and rate of potential carbon tax implementation Key questions include when these countries might introduce a carbon tax and what the applicable rates will be Rational investors must factor in these uncertainties during project appraisal to enhance the reliability of financial indicators, ultimately allowing for more confident investment decisions.
2.5.2 Taxpayers and rates of carbon tax.
Carbon taxes target emissions from sources such as coal-fired power plants and fossil fuels like coal, crude oil, and natural gas As of 2013, the US-based Center for Energy and Climate Change Solutions reported that 72% of carbon emissions originated from energy and energy-intensive industries, including steel and construction materials, while agriculture contributed 11%, land development and deforestation 6%, and transportation 2.2% Consequently, projects involving coal, oil, and gas, such as electricity generation and cement production, are significant contributors to emissions These initiatives often entail extensive preparation, high costs, and can result in irreversible environmental impacts.
Carbon taxes aim to lower greenhouse gas emissions, promote low carbon technology development, and generate revenue for carbon mitigation efforts These taxes can be levied on emission sources like coal and oil, or directly on firms responsible for emissions, particularly energy-intensive industries Research from developed nations indicates that imposing carbon taxes on companies utilizing emission materials can mitigate the adverse effects of taxation, encouraging firms to invest domestically rather than seeking lower-cost, tax-free environments in developing countries.
Many scholars agree that carbon tax rates should generate sufficient revenue to offset the social costs associated with emissions However, accurately calculating these social losses is complex, necessitating advanced modeling and extensive data analysis A survey by Marron & Toder (2014) of 75 studies on carbon tax design reveals significant variability in the estimated social loss costs, averaging USD 196 per ton of carbon, with a standard deviation of USD 322 (based on 2010 prices).
Research gaps
The literature review highlights the significance of understanding investment decisions under uncertainty, particularly for academic scholars, business executives, and investment advisors Key uncertainties, especially those related to taxation, play a crucial role in influencing Foreign Direct Investment (FDI) decisions Both theoretical and empirical studies consistently indicate that the imposition of taxes negatively impacts investment levels among firms, underscoring the need for further research in this area.
The impact of uncertainties linked to carbon taxation on firms' investment decisions in irreversible projects remains underexplored, with limited theoretical and empirical studies available Notably, research such as Sekar (2005) and Shahnazari et al (2014) has focused on case studies examining how carbon taxation uncertainties influence coal-fired power projects in Australia.
In a study by & et al (2006), the application of Return on Assets (ROA) was used to model technology selection amid uncertainties related to carbon taxation in Australia's power generation sector This research focused on projects utilizing two distinct technologies, leading to varying carbon emissions and significant differences in carbon tax costs when such taxes are implemented While these findings may be relevant for similar projects, they cannot be generalized to inform macro policies across different investment projects or the broader economy With carbon taxation anticipated to be enforced soon, investor interest is growing (Barradale, 2014) Barradale's conclusions align with the ACCA's 2012 report, which predicts an increase in carbon taxation, although the specific rates and growth trajectories remain uncertain.
Research on the impact of carbon taxation uncertainties on firms' investment decisions in irreversible projects remains scarce, highlighting a significant gap that this thesis aims to address.
The analysis of theoretical research highlights the impact of general and tax-related uncertainties on firms' investment decisions in irreversible projects, focusing on capital stock (K) and labor level (L) as key inputs These factors represent the scale of investment and domestic labor utilized in projects The capital-labor ratio (K/L) serves as a crucial indicator of a firm's technological advancement; a higher ratio suggests greater worker efficiency per unit of capital, indicating the use of more advanced technology This correlation is supported by Sollow (1957) and further empirical evidence from Kim (1997) Additionally, Broersma & Oosterhaven (2004) found that variations in the capital-labor ratio significantly influence firm productivity, with increases in the ratio leading to enhanced productivity levels.
The existing theoretical research primarily examines the impact of uncertainties on corporate value and net present value, rather than exploring how these uncertainties influence the selection of capital (K) and labor (L) to maximize profits This highlights a significant research gap that this thesis aims to address, providing valuable insights for policy development to enhance capital and technology levels, as well as labor quality in investment projects, particularly in foreign direct investment (FDI) Additionally, China has recently begun to consider implementing an export carbon tax on energy-intensive exports to reduce carbon emissions and promote energy-efficient production, which serves as an indicator of technological advancement in production (Li et al., 2012).
The current state of technology and labor in Foreign Direct Investment (FDI) projects in Vietnam is concerning, necessitating measures to enhance both Foreign parties typically dictate production technology due to their significant investment stakes and superior knowledge of technology and markets Often, they introduce outdated technologies or refurbished equipment that may be economically viable in Vietnam due to lower input costs and government incentives, despite being inefficient in developed countries A lack of research on policies to elevate capital, technology, and labor quality in FDI projects hinders the development of effective strategies Furthermore, inadequate administrative controls on obsolete technologies and limited technology assessment capabilities exacerbate environmental concerns Therefore, comprehensive research is essential to improve capital, technology, and labor standards in Vietnam's FDI projects.
Conclusion of Chapter 2
Foreign firms' investment decisions in FDI projects are influenced by various uncertainties, encompassing both quantitative factors such as exchange rates, market prices, capital costs, inflation, and taxes, as well as qualitative factors like institutional quality, investment location, legal stability, political stability, and diplomatic relations It is essential for investors to factor in these uncertainties, which may escalate into significant risks, when developing their investment decision models As rational investors, firms prioritize profit maximization while navigating these uncertainties, necessitating a comprehensive assessment of risks during the investment appraisal process.
Firms are increasingly worried about the uncertainties surrounding carbon taxation, anticipating its future implementation and potential increases in tax rates in countries where it is already in effect However, research on the impact of carbon taxation on investment decisions has primarily been limited to case studies of specific projects, making it challenging to generalize findings across entire sectors or economies, as well as for other types of irreversible investments.
This thesis aims to address the research gap in the theoretical model concerning firms' investment decisions amid the uncertainties of carbon taxation related to irreversible projects Additionally, it seeks to establish a scientific foundation for policy recommendations that enhance the quality of technology and labor, which are critical issues in Vietnam today.