Carbon pricing under uncertainty

International Tax and Public Finance https://doi.org/10.1007/s10797-021-09686-x Carbon pricing under uncertainty Frederick van der Ploeg1,2 Accepted: 28 June 2021 © The Author(s) 2021 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. Keywords Social cost of carbon · Asset pricing · Carbon pricing · Risk and uncertainty · Disasters · Temperature cap JEL Classification D81 · G12 · H43 · Q54 · Q58 1 Introduction Global warming is in part caused by man-made emissions resulting from combustion of fossil fuel. Scientists know what needs to be done to avoid a climate catastrophe: emissions must be brought down now and rapidly. If nothing is done to curb the use of oil, gas, and coal and to replace these sources of energy by solar, wind, and other forms of renewable energy, the heating of the planet will * Frederick van der Ploeg 1 Department of Economics, University of Oxford, Manor Road Building, Oxford OX1 3UQ, UK 2 Faculty of Economics and Business, University Amsterdam, P.O. Box 15551, 1001 NB Amsterdam, The Netherlands 13 Vol.:(0123456789) F. van der Ploeg continue relentlessly. Despite hopeful signs in Europe (mainly the European market for emissions permits) and the USA (the election of President Biden with an ambitious agenda for climate policy) and China’s commitment to go carbon net zero by 2060, India and various other countries rely on coal for cheap energy and will try to delay the green transition. Furthermore, oil-, gas- and coal-producing countries such as Saudi Arabia, Russia, Algeria, and others have no interest in the green transition either. Most economists recommend policy makers to implement a uniform carbon price throughout the globe and to have transfers from rich to poor countries to make sure all countries are on board. Furthermore, policy makers should commit to a path of rising carbon prices for the next three or four decades so businesses can plan their long-term investments to be in line with a carbon-free economy. The most common approach used by economists has been to set the carbon price to its Pigouvian price, which in climate economics is called the social cost of carbon (SCC). The SCC is the expected present discounted value of all damages done to the economy resulting from emitting one ton of carbon today. We discuss this concept at length in Sect. 2 and derive a tractable expression for the SCC. We show how the SCC needs to be adjusted for macroeconomic uncertainty, the risk of macroeconomic disasters, but also depends on climatic and damage ratio uncertainties. We also discuss the effects of a declining term structure of the discount rate on the carbon price. We then calibrate and find using the latest econometric evidence on damages from global warming (Burke et al., 2015), a simple model relating temperature to cumulative emissions (e.g. Allen et al., 2009; Matthews et al., 2009), and the macroeconomic disaster model for a market-based estimate of the discount rate (Barro, 2006, 2009) that the optimal carbon price is about $100 per ton of emitted CO2. This price should subsequently grow at a rate equal to the trend rate of growth of the economy. If the risks of climatic tipping points are taken account of, the carbon price can become much higher again (Cai and Lontzek, 2016) and cascading tipping points can push up the carbon price much further (Lemoine & Traeger, 2016; Cai and Lontzek, 2016). Given the debates about whether to use a prescriptive ethics- or descriptive market-based calibration of the discount rate and the much lower damages used in most integrated assessment models (e.g. around $15 per ton of CO2 in the DICE model of Nordhaus (2017)), there is an embarrassingly wide range of recommended carbon prices which is not very helpful for policy makers. It is thus not surprising that policy makers and the negotiators of the Intergovernmental Panel on Climate Change have adopted a more pragmatic approach. At the Paris Agreement signed in 2016, it was agreed to keep global mean temperature growth well below 2° and to aim for a cap of 1.5 °C. We show in Sect. 3 that this temperature cap implies an upper limit on global cumulative emissions and shows how this upper limit is affected by temperature sensitivity uncertainty and risk tolerance. We show that this upper limit requires a time path of the carbon price that grows at a rate equal to the interest rate corrected for risks to the rate of economic growth and to marginal abatement costs. This so-called Hotelling rule is not welfare based but cap based and corresponds to a more pragmatic approach. 13 Carbon pricing under uncertainty Risks in conducting climate policy not only derive from uncertainty about the climatic system, global warming damages, or economic growth prospects, but also from uncertainty about government policy and the risk of policy tipping or from uncertainty about the sudden drops in the cost of fossil fuel or renewable energy resulting from technological breakthroughs (e.g. the invention of horizontal drilling for shale gas). We show in Sect. 4 that this and more generally a disorderly transition to the green economy can lead to the risk of stranded assets provided investments once made are difficult to shift from carbon intensive to green sectors, and vice versa. This provides a case for financial regulators to regularly conduct climate stress tests. Finally, we offer in Sect. 5 a brief review of the obstacles to successful carbon pricing and in Sect. 6 a brief conclusion and some suggestions for further research. 2 Adjusting the Pigouvian carbon price for economic and climatic risks A very popular approach to finding the right price of carbon is to assume away all other market failures and imperfections and consider the optimal carbon pricing policy for the global economy. The revenues from the carbon tax (or from selling emission permits) are rebated in lump-sum fashion to the private sector. Hence, important problems such as une (...truncated)