Carbon pricing under uncertainty

Abstract

Economists have adopted the Pigouvian approach to climate policy, which sets the carbon price to the social cost of carbon. We adjust this carbon price for macroeconomic uncertainty and disasters by deriving the risk-adjusted discount rate. We highlight ethics- versus market-based calibrations and discuss the effects of a falling term structure of the discount rate. Given the wide range of estimates used for marginal damages and the discount rate, it is unsurprising that negotiators and policy makers have rejected the Pigouvian approach and adopted a more pragmatic approach based on a temperature cap. The corresponding cap on cumulative emissions is lower if risk tolerance and temperature sensitivity are more uncertain. The carbon price then grows much faster than under the Pigouvian approach and discuss how this rate of growth is adjusted by economic and abatement cost risks. We then analyse how policy uncertainty and technological breakthrough can lead to the risk of stranded assets. Finally, we discuss various obstacles to successful carbon pricing.