SUMMARY The thesis: "Investment decisions under uncertainty – The case of carbon taxation in developing countries" takes Vietnam as a typical one, aims to study the impact of uncertainti
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 Consequently, the topic of "investment decision under uncertainty" has become a prominent area of academic research, 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 significant profits in the medium to long term and drive substantial growth for firms However, such investments carry considerable risks due to uncertainties in both internal and external environments External uncertainties include market fluctuations, such as price changes and market size, competitive responses to the firm's large projects, the potential emergence of new technologies that could render the firm's technology obsolete, as well as changes in regulations, laws, and political stability in the project's intended location.
Uncertainties can significantly raise investment costs during both the project investment and commercial production phases, leading to increased production expenses, reduced competition, and diminished profitability As rational investors, firms remain vigilant about these uncertainties To manage them effectively, companies and their consulting experts strive to quantify and transform uncertainties into manageable risks, allowing for better predictions of occurrence probabilities and associated costs This proactive approach enhances the financial appraisal of projects, ultimately increasing the likelihood of their success (Munns & Bjeirmi, 1996).
After World War II, Western multinational enterprises experienced significant market expansion, driven by rapid economic growth in many Western countries This growth enabled large corporations to invest heavily in overseas projects for higher profits, shifting focus from domestic production and exports Consequently, fierce investment competition emerged among multinational corporations, particularly as strong economies sought to influence potential investment destinations for competitive advantages This competitive landscape pressured these enterprises to make quicker investment decisions, often in the face of limited information and high uncertainty, necessitating a willingness to accept greater risks in their investment choices.
Many countries advocate for international economic integration while simultaneously imposing trade and investment barriers to protect domestic firms These barriers manifest as technical obstacles, complex regulations, and a lack of transparency in the investment environment Additionally, unclear interpretations of investment policies and restrictions influenced by local cultures, religions, and environmental concerns further complicate the landscape Such policies create significant uncertainty, deterring foreign investment and hindering international trade for foreign enterprises.
The increasing uncertainties and their elevated levels pose significant challenges for companies' investment decisions, driving the need for further research in this area.
Investment decisions under uncertainty are increasingly relevant, particularly as multilateral and bilateral trade and investment policies evolve, creating optimal opportunities for firms in member countries Host governments must comprehend the behaviors of foreign firms to formulate effective policies that attract investment Vietnam is actively participating in global economic integration through international trade and investment agreements, which alters the external environment for firms Consequently, the factors influencing investment decisions are growing in both quantity and 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 measure Although developing countries like Vietnam have not yet adopted mandatory carbon emission reductions, the possibility exists for future implementation Consequently, Vietnam's investment environment 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 According to Yang et al (2008), the risk of carbon taxation is expected to increase after 2012 As a developing nation, Vietnam prioritizes attracting foreign direct investment, especially for large, irreversible projects.
Vietnam is projected to require an investment of approximately 608 billion USD in infrastructure from 2016 to 2040, according to forecasts by the Global Infrastructure Hub and Oxford Economics A significant portion of this investment, around 265 billion USD, is expected to be directed towards large-scale fossil fuel energy projects Such substantial investments necessitate collaboration between local governments and both domestic and foreign companies Additionally, foreign firms must consider carbon-related uncertainties when making investment decisions, particularly in light of potential future carbon taxation.
Academic research on investment decisions under uncertainty can be categorized into two primary strands: theoretical studies focusing on investment decision-making amidst uncertainty, and empirical investigations examining significant uncertainties such as price volatility, rising costs, exchange rate fluctuations, and tax implications that influence investment choices.
In theoretical research, notable authors such as Lucas & Prescott (1971), Hartman (1972), Abel (1983), and Dixit & Pindyck (1994) have established that an increase in a firm's marginal profit function due to heightened uncertainty incentivizes greater investment and production levels Additionally, Pindyck (1991) and Dixit & Pindyck (1994) highlighted the concept of investment irreversibility in large-scale projects, indicating that investors may choose to delay investments amid increased uncertainty, opting to wait for more favorable information to ensure future profitability.
Increased uncertainty can lead to an option value of waiting, as valuable information may emerge in the future Theoretical research on the link between uncertainty and investment identifies two main types: (1) timing uncertainty, which influences when to invest, and (2) uncertainty regarding the level of investment itself.
The theoretical research on "investment decisions under uncertainty" indicates that uncertainties related to taxation can significantly reduce foreign direct investment (FDI) Pindyck (1986) demonstrated that tax policy uncertainty leads to decreased investment levels among firms This finding was corroborated by Hassett & Gilbert (1999), who employed a randomized continuous-time algorithm in their analysis Additionally, Alvarez et al (1998) found that investors are likely to accelerate investments if they anticipate a decrease in tax rates, while Hassett & Metcalf (1999) and Agliardi (2001) confirmed 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 not yet materialized, they significantly influence investment choices Studies focus on developing net present value (NPV) models through algorithms and computational simulations, specifically analyzing potential options related to future uncertainties like carbon taxation Notably, this research has been applied to specific projects, including coal-fired power plants and iron and steel plants.
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 new theoretical framework by constructing a mathematical economic model that represents a firm's profit function in investment projects, incorporating the uncertain impacts of carbon taxation The model integrates Varian's (1992) profit function with the variable of carbon tax, influencing investment decisions Following the model's development, an optimization algorithm will be employed to analyze the interplay between the carbon tax and other components of the profit function, such as capital stock (K) and labor level (L) The findings will be interpreted to formulate relevant theoretical proposals.
This thesis aims to identify research gaps through a review of theoretical and empirical studies, focusing on the development of a mathematical model to address these gaps It will specifically examine how uncertainties related to carbon taxation influence the investment decisions of investors from developed countries, particularly those involved in irreversible projects in developing nations like Vietnam By creating mathematical models and conducting calculations, the research will analyze investment decisions and the selection of capital, technology, and labor levels in foreign direct investment (FDI) projects in Vietnam, considering the uncertainties associated with carbon taxation.
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
The thesis focuses on how foreign firms make investment decisions in irreversible projects amid uncertainties related to carbon taxation, which is increasingly adopted in developed countries to promote sustainable development and is expected to be implemented in Vietnam soon It will analyze the effects of these uncertainties on investment behavior, particularly regarding the optimal choices of capital, technology, and labor that foreign investors can make for their projects in Vietnam.
The findings of this research suggest actionable managerial and policy recommendations aimed at attracting higher-quality foreign direct investment (FDI) projects These strategies focus on minimizing environmental impacts while simultaneously enhancing the quality of technology and labor associated with these investments.
This research focuses on the significant fixed assets of foreign companies in Vietnam that contribute to carbon emissions, highlighting the associated risks of uncertainty and carbon taxation in these projects Known as irreversible investment projects (McDonald & Siegel, 1986), these high-value initiatives include essential commodities and infrastructure in sectors such as transportation, telecommunications, energy, oil and gas, power generation, oil refining, steel production, chemical manufacturing, and real estate Typically, these projects are undertaken by large multinational enterprises (MNEs/MNCs) from developed nations Given the trend of carbon tax avoidance from developed countries to developing nations with no carbon taxation, the findings of this study in the Vietnamese context can be applicable to other developing countries.
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, focusing on investment decisions under uncertainty related to future carbon taxation in Vietnam, where similar studies are lacking Utilizing qualitative methods, such as in-depth interviews with experts, may reveal significant biases due to the absence of current carbon tax-related uncertainties, making discussions about future implications challenging.
Relying on interviews for information from Multinational Enterprises (MNEs) is not a reliable method for analysis, as quantitative research requires empirical data to test hypotheses However, since carbon taxation has not yet been implemented, obtaining such data is unfeasible, making empirical quantitative methods unsuitable This thesis proposes the use of quantitative methods through algorithmic modeling and computational simulations By modeling a firm's profit function in relation to uncertainties surrounding carbon taxation, and employing mathematical techniques for calculations, the study aims to address the impact of these uncertainties on the firm's investment decisions regarding capital, technology, and labor levels.
The profit function model proposed by Varian (1992) has been selected for its advantages over the traditional net present value (NPV) approach According to Varian (1992, p 23), this model is structured in a general form that effectively captures the firm's profitability.
- 𝜫: 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
The average selling price of products, denoted as \$p\$, is influenced by the firm's continuous investment when \$\pi > 0\$, as they aim to maximize profits as rational investors Consequently, the firm strategically selects optimal input levels of capital (\$K\$), labor (\$L\$), rental rate (\$r\$), and wage rate (\$w\$) to achieve this 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 carbon taxation in investment decisions for irreversible projects Chapter 2 will establish a theoretical framework and present empirical evidence, prioritizing the impact of carbon taxation The mathematical model developed in the thesis is anticipated to yield significant theoretical insights, revealing that carbon taxation may deter low-tech investors As a result, if utilized as an adjustment tool, the government could formulate carbon tax-related policies to elevate the quality of foreign direct investment (FDI) projects, marking a novel contribution of the thesis.
The thesis employs 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 for academic practice in Vietnam.
This thesis examines various methods of project appraisal, specifically Discounted Cash Flow (DCF) and Return on Investment (RO), for large asset projects that significantly impact industry 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 project 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 outlines key components including the research context, motivation, targets and objectives, scope, and anticipated outcomes, highlighting both academic significance and practical applications.
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 carbon tax is currently not implemented, but it is anticipated to be enforced throughout the project life cycle This will influence the investment decision-making of two distinct firms as they choose their levels of capital, technology, and labor, all under the same carbon tax rate The theoretical outcomes of these scenarios will be outlined to 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 established for profit, operating under the law with profit as its ultimate goal (Chandler, 1992) All activities within a firm are strategically designed to generate profits in the short, medium, and long term Initially, firms primarily focused on trading goods, which involved buying, storing, sorting, preliminary processing, packaging, and transportation.
The evolution of firms from artisanal to industrial production marks a significant shift towards service-oriented models, where machinery and equipment play a crucial role According to the author, the development of a firm hinges on three key factors: continuous learning and experience of managers and employees, advanced production equipment and technology, and sufficient capital.
The emergence of the multinational company model coincided with the expansion of firms into manufacturing establishments across various countries The East India Co., Ltd., founded in 1600, is recognized as the first multinational company, engaging in the purchase, transportation, storage, and sale of agricultural products, as well as the exploitation of colonial resources and investment in agriculture within the colonies for import back to the United Kingdom (Sen, 1998).
The modern industrial enterprise, which began to take shape in the 1880s, has evolved significantly and continues to thrive today (Chandler & Hikino, 2009) These enterprises are defined by a combination of highly educated labor and advanced machinery, leading to capital-intensive production This integration enables the optimization of production inputs, resulting in economies of scale; as production increases, the unit cost decreases.
Modern industrial enterprises primarily operate in sectors that require advanced technology and equipment, including automobile assembly, transportation, energy, oil and gas, chemicals, and pharmaceuticals Recently, new players have emerged, particularly in digital services and information-communication technology, with companies like Intel, Google, Microsoft, Apple, and Samsung leading the way Many firms in the S&P 500 are classified as large industrial or technology enterprises, focusing their investments on large-scale projects that involve significant capital and complex technologies, necessitating a highly skilled workforce and the production of high-tech products and services.
The firm not only serves as a producer and supplier of goods but also functions as an investor, consistently seeking opportunities to invest This strategy is aimed at preserving its traditional market position while also exploring new potential markets.
In 2015, industrial enterprises increasingly prioritize the identification, assessment, and decision-making processes related to substantial industrial projects Consequently, these large industrial projects are viewed as strategic investments essential for the growth and success of modern industrial enterprises.
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, denoted as \$q\$, where profit (\$𝜫\$) is calculated as the difference between total revenue (\$pq\$) and production costs (\$C(q)\$) Here, \$p\$ represents the average selling price, while \$C(q)\$ indicates that production costs increase with higher output levels The profit maximization function is established to ensure that \$𝜫\$ reaches its highest value at the chosen output level.
The Cobb-Douglas production function, represented as \$q = AK^\alpha L^\beta\$, illustrates the relationship between a firm's output (q) and its inputs, capital (K) and labor (L) This foundational equation can be expanded to incorporate additional production costs, such as future taxes, thereby providing a more comprehensive understanding of the profit function in relation to operational expenses.
Modern companies, including large family-owned businesses, are often managed by a team of closely governed managers who follow strict internal governance policies These policies are designed to ensure that all business operations focus on maximizing profits or dividends for shareholders, as agreed upon and strictly adhered to by board members.
Internal governance policies can be adjusted based on the current production and business conditions to optimize profits Consequently, firms, acting as investors, are inclined to make rational decisions grounded in the most reliable information and evidence, while minimizing emotional biases (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 may yield lower financial returns but offer greater social impact, highlighting a fundamental difference in investment motivations.
To maximize profits and thrive in a competitive landscape, firms must adopt effective governance practices, reduce operational costs, and seek new customers while expanding their market reach Additionally, continuous research and strategic investment in promising new projects are essential for achieving medium- and 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 certain low-risk options like government bonds from stable economies, which are viewed as non-risk portfolios.
Investment is characterized by three key elements: a commitment to allocate capital over time, exposure to inflation, and susceptibility to uncertainty or risk regarding future returns (Reilly & Brown, 2002) Activities such as purchasing and holding materials, commodities, stocks, bonds, financing struggling companies, lending, and injecting capital into new projects are all classified as investment activities From an economic standpoint, in a perfectly competitive market, 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, firms 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 expanded into new markets, making foreign direct investment (FDI) a crucial element in global economic development (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 foreign markets FDI allows companies to access raw materials more easily, reducing reliance on imports, while enabling the allocation of specialized labor and production facilities to achieve economies of scale For instance, firms can utilize foreign production lines for initial processing and then import the refined products for further completion Additionally, FDI serves as a strategic tool to circumvent trade barriers and lower transportation costs Dunning (1971) posited that FDI acts as a defensive strategy for firms to mitigate risks associated with over-dependence on their home economies, while Watters (1995) noted that FDI projects help firms overcome domestic market constraints, particularly in saturated markets.
Foreign direct investment (FDI) encompasses various forms, including establishing representative offices, joint ventures, and acquiring shares in domestic companies It is defined as the establishment of a firm in a host country by a foreign entity, which can be 100% foreign-owned or a joint venture According to UNCTAD, a firm is classified as an FDI if a foreign party owns 10% or more of its voting capital FDI offers several advantages for foreign investors, such as access to low-cost domestic resources, insights into local market behaviors, and the ability to create a diversified production network across countries However, FDI in developing countries carries risks, including political instability, inadequate legal frameworks, and fluctuating tax systems Research on FDI typically focuses on its benefits and the potential drawbacks, such as resource over-exploitation and environmental degradation caused by outdated technologies.
Foreign Direct Investment (FDI) offers several significant benefits to host countries, including increased wages and employment opportunities (UNCTAD, 2004), the utilization of local raw materials and inputs that foster domestic investment (Javorcik et al., 2007; Kneller & Pisu, 2007), and positive spillover effects to local firms Additionally, FDI facilitates technology transfer, enhancing productivity in domestic companies (Kokko et al., 1996; Gorg & Strobl, 2001; UNCTAD, 2004; Potterie & Lichtenberg, 2001), contributes to higher exports 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 developed nations at various levels These factors can be categorized into three main groups: characteristics of the firm, characteristics of the investment project, and external factors such as exchange rates, tax policies, institutional quality, and trade protections Root and Ahmed (1978) further classified these influences into four categories: economic factors (e.g., GDP, infrastructure development), social factors (e.g., human resource quality, urbanization), political factors (e.g., government stability, internal conflicts), and government policy-related factors (e.g., FDI taxes, regulations on foreign manpower) This thesis particularly addresses the uncertainties surrounding taxation in the context of FDI.
Tax uncertainty significantly reduces project profitability, prompting investors to clarify statutory tax liabilities and assess potential future tax rate increases, including environmental and carbon emissions taxes Research, such as that by Root & Ahmed (1978), indicates that rising corporate taxes 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) demonstrated that corporate income tax reductions positively influenced FDI inflows in Central and Eastern Europe from 1995 to 2003 Overall, studies consistently show that the tax rates and policies of FDI host countries significantly affect FDI inflows, highlighting that investors are cautious regarding tax-related uncertainties when considering FDI projects.
Irreversible project
Foreign Direct Investment (FDI) prioritizes large and irreversible projects, which are crucial for a robust economy These significant capital projects demand extensive preparation, with firms typically investing about 10% of the total capital in activities such as surveys, market research, and feasibility studies before making an investment decision Such projects involve design, equipment procurement, and construction According to Archibald & Voropaev (2004), irreversible projects are categorized into specific groups, highlighting their importance in economic development.
Key infrastructure projects, including transport and telecommunications, as well as energy initiatives like refineries and power plants, are crucial for robust economies Developing nations, such as Vietnam, face an urgent need for investment in large-scale fixed asset projects, which are essential for sustainable growth Consequently, prioritizing investment in these vital sectors is imperative for the advancement of any country, particularly those in the developing world.
1 Aerospace/Defense Projects 1.1 Defense systems
New weapon system; major system upgrade Satellite development/launch; space station mod Task force invasion
2 Business & Organization Change Projects 2.1 Acquisition/Merger
2.2 Management process improvement 2.3 New business venture
2.4 Organization re-structuring 2.5 Legal proceeding
Acquire and integrate competing company Major improvement in project management Form and launch new company
Consolidate divisions and downsize company Major litigation case
3 Communication Systems Projects 3.1 Network communications systems 3.2 Switching communications systems
Microwave communications network 3rd generation wireless communication system
4 Event Projects 4.1 International events 4.2 National events
2004 Summer Olympics; 2006 World Cup Match
Closure of nuclear power station
Demolition of high rise building
5.2 Facility demolition 5.3 Facility maintenance and modification 5.4 Facility, design, procurement, construction in Civil, Energy, Environmental, High rise, Industrial, Commercial, Residential, Ships
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 International Development Projects 7.1 Agriculture/rural development 7.2 Education
7.3 Health 7.4 Nutrition 7.5 Population 7.6 Small-scale enterprise 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 projects, distinct from facility projects, encompass various sectors such as industrial, telecommunications, transportation, urbanization, water supply, sewage, and irrigation These projects typically involve establishing an organizational entity responsible for the operation and maintenance of the facility Additionally, lending agencies enforce specific project lifecycle and reporting requirements.
8 Media & Entertainment Projects 8.1 Motion picture
8.2 TV segment 8.2 Live play or music event
New motion picture (film or digital) New TV episode New opera premiere
9 Product and Service Development Projects
9.1 Information technology hardware 9.2 Industrial product/process
9.3 Consumer product/process 9.4 Pharmaceutical product/process 9.5 Service (financial, other)
New automobile, new food product New cholesterol-lowering drug
New life insurance/annuity offering
10 Research and Development Projects 10.1 Environmental
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 those in refineries, power plants, and chemical facilities, involve multiple design stages and substantial project preparation costs These large asset projects 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 potential for projects to be paused while awaiting more favorable information, enabling investors to make informed decisions based on factors like rising product prices, reduced initial costs, or improved project policies.
Irreversible investment projects, such as high-value production initiatives, infrastructure developments, power plants, and oil refineries, often span a lengthy project life cycle of 20 to 30 years or more These projects are characterized by their extended duration, making them significant undertakings in the fields of energy and resource exploitation.
Investment projects often require a substantial initial capital outlay and a lengthy preparation period that includes design, equipment procurement, and construction The decision-making process for these investments can be extended due to various uncertainties and the need to evaluate extensive information 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 preliminary investment preparation and research During this stage, the project is assessed from various angles, particularly its alignment with the firm's strategic goals Comprehensive analyses are conducted and documented in a pre-feasibility study (Pre-F/S) to aid in decision-making regarding whether the project should advance to the next stage, the detailed feasibility study (Detailed F/S), or not.
Phase 2, known as the Intermediate/Development stage, is crucial in the investment preparation period, as it centers around the feasibility study This study aims to quantify inputs for project evaluation as accurately as possible, with financial analyses, including key indicators like NPV, IRR, and B/C, calculated with precision The investment decision is made upon the completion of the feasibility study, ensuring that the total project investment cost is determined based on reasonable assumptions However, uncertainties may arise during this decision-making period, prompting rational investors to pause their investment decisions until more favorable information is available or the level of uncertainty diminishes.
Phase 1 an acceptable level The pause of project investment decision to wait for better or clearer information is called as the "wait and see" status (Bjerksund & Ekern, 1990; Stokey, 2016) For the firm, making investment decision in irreversible projects (Dixit
Strategic financial decisions, including project investment preparation, play a crucial role in enhancing corporate value and stock prices Early investment in project preparation, coupled with effective public relations, can significantly increase the market value of a project, ultimately benefiting the overall value of the firm.
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, as canceling it would result in significant financial losses due to the high total expenditures, which are now considered sunk costs.
Phase 4, known as the Final Phase or Transfer, occurs after the execution phase (Phase 3) is completed During this stage, the project transitions into a trial and commercial operation period, where the product or service is produced and sold in the market.
By the end of the second phase, investors typically allocate 5-10% of the total project investment cost to market surveys, research, project design, and feasibility studies (Burke, 2003) If the project is canceled, this expenditure is lost, as the feasibility study cannot be repurposed for another project During the feasibility study phase, significant uncertainties may lead investors to adopt a "wait-and-see" approach, pausing their investment decisions until more favorable information emerges.
CASE STUDY OF IRREVERSIBLE AND REVERSIBLE PROJECTS
The author has identified a lack of empirical studies that quantitatively differentiate between two types of projects based on capital or labor scale The primary distinction lies in the size of the sunk cost incurred by investors, which cannot be recovered if a project is abandoned; higher sunk costs indicate greater irreversibility Numerous real-world examples illustrate both irreversible and reversible projects, highlighting the complexities involved in investment decisions for these categories.
The Nghi Son refinery and petrochemical project, a collaboration between the Vietnam Oil and Gas Group (PVN), Idemitsu Group, Mitsui Chemical, and Kuwait National Oil and Gas Group, exemplifies an irreversible project with a total investment of approximately $9 billion Approved by the Vietnamese government and included in the master plan since 2003, the project underwent extensive preliminary design and cost estimation Following the master plan's approval, investors dedicated five years to detailed feasibility studies before making the investment decision in 2008, resulting in sunk costs amounting to several hundred million USD.
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 investment in financial instruments like stocks, bonds, and intangible assets such as intellectual property, patents, copyrights, and trademarks These decisions can be made rapidly based on market conditions, particularly the current state of the stock and financial markets Firms have the flexibility to either hold these highly liquid financial assets for the long term or sell them quickly.
Strategic investment decisions involve significant, irreversible projects that require substantial capital and are crucial for maintaining a firm's market position in the medium to long term According to Al-Ajmi et al (2011), these decisions are vital for firm management, promoting long-term development and enhancing firm value However, such irreversible projects are often subject to various uncertainties that can impact expected returns, prompting extensive research by numerous authors on investment decisions under uncertain conditions, both theoretically and empirically.
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 aim to maximize their value Abel (1983) examined the effect of price volatility on the investment levels of neutral risk investors, utilizing mathematical models based on the Cobb-Douglas production function, which incorporates capital stock (K) and labor (L) as key inputs His findings aligned with those of Hartman (1972), indicating that an increase in selling price enhances the value of marginal capital, prompting firms to invest more Furthermore, Abel & Eberly (1994) expanded the firm value model (V) to account for the expected total operating profit (𝜫) minus total operating costs throughout the project lifecycle, incorporating the uncertainty of the shadow price (q) of installed capital.
Eberly (1994) found that firms consistently aim to maximize their value (V) by optimizing their capital stock (K) and technology (ɛ), which are the two primary inputs in their production process.
Caballero (1991) summarizes the researches of Hartman's (1972) study, Abel
The relationship between uncertainties and investment in building a firm's value model (V) is influenced by profit (𝜫), capital (K), labor (L), and various costs in both perfect and imperfect competition markets Caballero (1991) found that the adjusted investment cost due to information asymmetry does not significantly impact this relationship; instead, the cost of investment capital and marginal profit from increased investment capital are crucial factors Dixit & Pindyck (1994) utilized a formula for Net Present Value (NPV) to analyze how product price, interest rates, and construction costs affect NPV, thereby influencing firm value (V) However, their findings are limited in generalizability due to the lack of a comprehensive NPV function compared to earlier works by Abel and others 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.
Recent research, with the exception of Dixit & Pindyck (1994), shares common characteristics: (1) these studies utilize firm value (V) alongside the profit function (𝜫), represented as gross or operating profit, which is influenced by key factors such as capital stock (K) and labor (L) These inputs are crucial for a firm's operations Additionally, the models incorporate various uncertainties, including product selling prices and capital costs, based on the assumption that firms aim to maximize their value or project profitability; (2) the profit function is typically modeled in a Cobb-Douglas form, emphasizing the roles of capital stock (K) and labor (L) as the primary inputs.
Research on investment decisions under uncertainty has focused on irreversible projects such as steel plants, coal-fired power plants, and real estate developments, which are significantly affected by future government policies For instance, the implementation of carbon taxation can greatly reduce the revenues of a coal-fired power plant 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 challenges Given that uncertainties can alter a project's expected profitability, the feasibility of such projects relies on the appraisal method used, with ROA proving effective in adapting to anticipated future uncertainties.
In a 2005 case study on project appraisal for a coal-fired power plant, researchers examined two technologies that produce varying levels of carbon emissions, resulting in different environmental costs and carbon taxation implications The study highlights that uncertainties related to carbon taxes significantly affect the project's operating costs, suggesting that the Net Present Value (NPV) may underestimate input costs compared to the Return on Assets (ROA).
Empirical research on the impact of uncertainty on firm investment decisions at the sector level reveals a variety of influences Studies have shown that fluctuations in inflation and US sales prices significantly affect investment levels, as evidenced by Citibank's data from 1954 to 1989 (Huizinga, 1993) Additionally, price fluctuations influence both current and future investments in US manufacturing firms (Ghosal & Loungani, 1996) Other research highlights the relationship between price volatility, product demand, and business investment (Peters, 2001), as well as the effects of stock market volatility on investment in developed economies (Lensink, 2002) Furthermore, exchange rate fluctuations have also been found to impact investment decisions (Byrne & Davis, 2005).
An overview of theoretical and empirical studies on "investment decision under uncertainty" reveals a diverse range of research Theoretical studies establish the firm's value function (V) as the profit function minus the cost function, which accounts for uncertainty The profit function is modeled as a Cobb-Douglas function with two inputs: capital (K) and labor (L) Key contributions from researchers such as Abel (1983), Caballero (1991), Pindyck (1990), and Abel & Eberly (1994, 1998) have developed models following this framework These studies focus on uncertainty factors, including product selling prices, capital investment costs in competitive markets, and issues related to asymmetric or proportional incomplete information A fundamental assumption in this research is that firms aim to maximize profits and/or business value.
Table 2.4 summarizes key publications that inform the foundational principles of this thesis, including the model structure, primary variables, and assumptions, which will be utilized to construct and enhance the research model.
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 (𝜫) 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 (𝜫)
Capital stock (K), labor level (L) 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
The rise in Earth's temperature is primarily due to the accumulation of greenhouse gas emissions, particularly carbon dioxide, in the ozone layer, leading to global climate change Carbon emissions originate from fossil fuel-based electricity production, transportation, and agricultural activities In 1997, the Kyoto Protocol was established in Japan, where numerous countries committed to reducing global emissions By 2011, 36 developed countries, including 29 European nations counted as one, pledged to implement various measures to lower carbon emissions These countries, classified as Annex I, along with 137 developing nations in the Non-Annex I category, agreed to future emission reductions Annex I countries have gradually adopted strategies such as emission quotas, carbon taxation, and promoting renewable energy to achieve their commitments.
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 invest in greener technologies to reduce their carbon footprint Empirical studies, such as those by Speck (1999) and others, have shown that carbon taxation effectively lowers corporate income and encourages technological advancements for reduced emissions Carbon taxes can be applied at various stages of the production chain, targeting either direct emitters or suppliers of carbon-intensive materials, a strategy known as vertical targeting (Bushnell & Mansur, 2011) For instance, a coal producer may be taxed, which subsequently affects the electricity generation plant and ultimately the end consumers of electricity.
According to Bushnell & Mansur (2011), direct carbon taxation on firms, particularly coal-fired power plants, can lead to "carbon leakage," where investors shift their investments to non-carbon taxed countries to avoid taxes (Babiker, 2005) This phenomenon encourages foreign investment in high carbon emission industries in developing nations, such as steel and chemicals, where carbon taxes are absent Studies suggest that imposing carbon taxes on upstream manufacturing processes is more effective than on downstream products, as the latter increases the risk of investment shifts to non-taxed countries For instance, applying carbon taxes on coal rather than on power plants can better limit carbon leakage Additionally, implementing other carbon-related taxes, such as border adjustment taxes, export carbon taxes, or carbon trading mechanisms, may further mitigate 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 refers to the relocation of production from countries with carbon taxes to those without, resulting in increased total carbon emissions due to the longer transportation of imported goods (Wei et al., 2016) While investing in greener technology can reduce carbon emissions, it often requires significant initial investment, making the cost of eco-friendly products higher than those produced with traditional methods Consequently, products made with green technology may struggle to compete on price, and the transition to such technologies can be time-consuming.
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
In the medium to long term, firms may strategically relocate their production equipment to non-carbon taxed countries, as noted by Branger & Quirion (2014) Alternatively, they can invest in new projects while retaining older technologies that maintain the same carbon emissions, leading to the importation of non-carbon taxed products back into carbon-taxed countries This practice, known as carbon leakage or investment for carbon tax avoidance, ultimately increases total carbon emissions due to the longer transport distances involved Consequently, the objectives of carbon taxation are undermined, particularly in developing countries like Vietnam, where lower input costs and investment incentives attract firms that are exempt from carbon taxes By investing in these regions, firms can enhance their price competitiveness, a trend that has gained momentum since the Kyoto Protocol in 1997.
Since the 1990s, a significant decline in world 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 doubled, while emissions from developed nations remained relatively stable During this period, imports from developing countries to developed nations nearly doubled, indicating that developed countries are indirectly responsible for higher carbon emissions through increased consumption Additionally, Peters et al (2009) argue that international trade has facilitated the transfer of carbon emissions from carbon-taxed countries, as outlined in the Kyoto Protocol (1997), to non-carbon-taxed countries.
Empirical studies indicate that the value of carbon leakage related investments varies across different industries Research by Paltsev highlights the geographical and sectoral differences in carbon leakage investments within the region.
Research on carbon leakage related investment shows significant variation, with estimates ranging from 5% to 130% Notably, Babiker (2005) highlighted a 130% rate due to the displacement of energy-intensive production subject to carbon taxation, contrasting with other studies that reported lower figures Babiker attributed these discrepancies to the use of different methodologies, as his computational model incorporated more variables Additionally, Elliott et al (2010) estimated a carbon leakage rate of 20% for countries in Annex B of the Kyoto Agreement.
Carbon leakage rates are widely regarded as uncertain, as noted by various authors (Barker et al., 2007; Harstad, 2010) Nevertheless, numerous empirical studies indicate a clear trend of increased carbon leakage-related investments shifting from countries with carbon taxes to developing nations that do not impose 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 Rational investors must consider these factors during project appraisal to enhance the reliability of financial indicators, ultimately enabling them to make more confident investment decisions.
2.5.2 Taxpayers and rates of carbon tax
Carbon taxes target emission sources, particularly fossil fuel-based industries like coal, crude oil, and natural gas As of 2013, the US-based Center for Energy and Climate Change Solutions reported that approximately 72% of carbon emissions originated from energy and energy-intensive sectors, including steel and construction materials Agriculture contributed 11%, while land development and deforestation accounted for 6%, and transportation using heavy fuel oil made up 2.2% Consequently, coal, oil, and gas projects, along with coal-burning operations such as cement and steel production, are significant contributors to emissions These initiatives often involve extensive preparation, high costs, and result in long-term, irreversible impacts.
Carbon taxes aim to achieve three primary objectives: reducing greenhouse gas emissions, promoting the development of low-carbon technologies, and generating tax revenue to fund carbon mitigation efforts (Marron & Toder, 2014) These taxes can be levied on emission sources like coal and oil, or directly on firms responsible for emissions, particularly those in energy-intensive industries Research from developed nations indicates that imposing carbon taxes on firms utilizing emission materials can help mitigate the adverse effects of carbon taxation, thereby encouraging firms to invest domestically rather than seeking lower costs in developing countries with fewer regulations (Bushnell & Mansur).
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 and necessitates advanced modeling and extensive data analysis A survey by Marron & Toder (2014) of 75 studies on carbon tax design reveals that the estimated social loss cost varies significantly, averaging USD 196 per ton of carbon, with a standard deviation of USD 322 (based on 2010 prices).
Many countries have reached a consensus on implementing carbon taxes based on either a fixed rate per ton of carbon emissions or as energy taxes calculated per kilowatt-hour (kWh) As of 2016, a total of 24 countries and territories, including certain special economic zones in China, have adopted carbon taxes or similar regulations Sweden leads with the highest carbon tax rate at 149.74 EUR per ton, followed by Switzerland at 60.61 EUR per ton.
EUR/ton of carbon Some countries have low carbon taxes like Mexico from 0.46-2.28 EUR/ton of carbon emissions (Zimmermannová et.al, 2016)
Research gaps
The literature review highlights the significance of researching investment decisions under uncertainty, which is valuable for academic scholars, business executives, and investment advisors Various uncertainties, particularly those related to taxation, significantly influence foreign direct investment (FDI) decisions The consensus among theoretical and empirical studies is that taxation adversely affects and reduces the investment levels of firms.
The research on the influence of uncertainties related to carbon taxation on firms' investment decisions in irreversible projects is notably scarce Limited studies, such as those by Sekar (2005) and Shahnazari et al (2014), have specifically examined the effects of carbon taxes on investment choices, focusing primarily on case studies like coal-fired power projects in Australia.
In their 2006 study, & et al utilized the Resource-Based View (ROA) to analyze technology selection amid uncertainties related to carbon taxation in Australia's power generation sector Their research focused on a specific project type involving two technologies that produce varying carbon emissions, leading to significant differences in carbon tax costs when imposed While these findings may apply to similar projects, they are not sufficient to generalize macro policies for diverse investment projects across the entire sector or economy With carbon taxation anticipated to be implemented soon, investor interest is heightened (Barradale, 2014) Barradale's conclusions align with the ACCA's 2012 report, which predicts an increase in carbon taxation in the coming years, although the specific rates and growth levels remain uncertain.
The existing research on the impact of carbon taxation uncertainties on firms' investment decisions in irreversible projects is notably scarce, highlighting a significant research gap that this thesis aims to address.
The analysis of theoretical research on general and tax-related uncertainties reveals that investment decisions in irreversible projects are fundamentally influenced by capital stock (K) and labor level (L) These inputs represent the size of investment capital and domestic manpower utilized in projects The capital-labor ratio (K/L) serves as a crucial indicator of a firm's technological development; a higher ratio suggests greater worker efficiency per unit of capital, indicating the use of advanced technology This relationship is supported by Sollow (1957) and Kim's empirical study (1997) Furthermore, Broersma & Oosterhaven (2004) highlight that variations in the K/L ratio significantly impact firm productivity, with increases in the ratio correlating to enhanced productivity levels.
The existing theoretical research primarily examines the impact of uncertainties on corporate value and net present value, rather than how these uncertainties influence the selection of capital (K) and labor (L) to maximize profits This represents a significant research gap that this thesis aims to address, providing valuable insights for policy development to enhance capital, technology levels, and labor quality in investment projects, particularly in foreign direct investment (FDI) Additionally, China is exploring the implementation of an export carbon tax on energy-intensive exports to mitigate carbon emissions and promote energy-efficient production, which serves as an indicator of technological advancement in manufacturing (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 technological knowledge Unfortunately, this often results in the introduction of outdated technologies or refurbished equipment, which, while economically viable in developed nations, may not align with Vietnam's development goals A review of existing literature reveals a lack of research on policies aimed at improving capital, technology, and labor quality in FDI projects This gap hinders the formulation of effective policies and highlights the inadequacy of Vietnam's regulatory framework regarding old technologies, which can contribute to environmental pollution Therefore, comprehensive research is essential to elevate the standards of capital, technology, and labor in Vietnam's FDI landscape.
Conclusion of Chapter 2
Foreign firms' investment decisions in FDI projects are influenced by various uncertainties and factors, both quantitative and qualitative Quantitative factors include exchange rates, market prices, capital costs, inflation, and taxes, while qualitative factors encompass institutional quality, investment location, legal stability, political stability, and diplomatic relations Investors must account for these uncertainties, as they can translate into significant risks in their decision-making models Rational investors prioritize profit maximization amidst these uncertainties, necessitating a thorough appraisal of all associated risks when considering investment projects.
Firms are increasingly concerned about the uncertainties surrounding carbon taxation, anticipating its future implementation and potential increases in tax rates in countries where it is already applied However, research on the impacts 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 investment projects.
This thesis addresses the research gap in the theoretical model concerning firms' investment decisions under the uncertainties of carbon taxation for irreversible projects Additionally, it aims to provide a scientific foundation for policy recommendations that enhance the quality of technology and labor, which are currently significant issues in Vietnam.