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Analyzing the Decision to Invest in Recycling: the Role of Demand Uncertainty and the Rebound Effect.
The reduction in the consumption of virgin material is considered one of the most important environmental benefits of the transition towards a circular economy. However, as positive externalities are not internalized and investors face demand uncertainty, private investment in the circular economy is lagging behind. This study analyses a monopolistic firm with the option to invest in a recycling facility, taking into account demand uncertainty. The analysis internalizes the environmental externalities of recycling, taking into account the rebound effect. Such rebound effects occur whenever recycled material does not fully displaces virgin material. On the one hand, the objective is to analyze the impact of environmental externalities of recycling on the decision to invest in a recycling facility. On the other hand, the discrepancy of investment thresholds between profit maximization and welfare maximization are calculated and analyzed. The theoretical framework is applied to a case study in the plastics waste industry. In order to incorporate demand uncertainty and environmental externalities, the real option theory is used. An existing real option model is extended by incorporating the environmental externalities of recycling. Using this extended model, the optimal investment thresholds i.e. the optimal investment trigger and the optimal investment capacity are calculated. We find that internalizing positive environmental externalities lowers the optimal investment threshold as well as the optimal investment capacity. The optimal capacity in which a firm invests in, increases in case of welfare maximization.