Optimal climate change mitigation under long-term growth uncertainty: Stochastic integrated assessment and analytic findings

Economic growth over the coming centuries is one of the major determinants of today׳s optimal greenhouse gas mitigation policy. At the same time, long-run economic growth is highly uncertain. This paper is the first to evaluate optimal mitigation policy under long-term growth uncertainty in a stochastic integrated assessment model of climate change. The sign and magnitude of the impact depend on preference characteristics and on how damages scale with production. We explain the different mechanisms driving optimal mitigation under certain growth, under uncertain technological progress in the discounted expected utility model, and under uncertain technological progress in a more comprehensive asset pricing model based on Epstein–Zin–Weil preferences. In the latter framework, the dominating uncertainty impact has the opposite sign of a deterministic growth impact; the sign switch results from an endogenous pessimism weighting. All of our numeric scenarios use a DICE based assessment model and find a higher optimal carbon tax than the deterministic DICE base case calibration.     

Climate change mitigation options and directed technical change: A decentralized equilibrium analysis

The paper considers an endogenous growth model with climate change as well as three R&D sectors dedicated to energy, CCS (Carbon Capture and Storage) and backstop efficiency. First, we characterize the set of decentralized equilibria: a particular equilibrium is associated with any vector of policy instruments including a carbon tax and a subsidy to each R&D sector. Second, we show that it is possible to express any equilibrium as the solution of a maximization program. Third, we solve the first-best optimum problem and thereby deriving the optimal instruments. Finally, we illustrate the theoretical model using calibrated functional specifications. In particular, we investigate the effects of various combinations of policy instruments (including the optimal ones) by determining the deviation of each corresponding equilibrium from the “laisser-faire” benchmark. We find notably that introducing an R&D subsidy hardly affects emissions when a carbon tax is already implemented, thus revealing a complementary effect between these two policy instruments.     

The Impact of Climate Change on the Balanced Growth Equivalent: An Application of <Emphasis Type="Italic">FUND</Emphasis>

The Stern Review added balanced growth equivalents (BGE) to the economic climate change research agenda. We first propose rigorous definitions of the BGE for multiple regions and under uncertainty. We show that the change in the BGE is independent of the assumed scenario of per capita income. For comparable welfare economic assumptions as the Stern Review, we calculate lower changes in BGE between a business as usual scenario and one without climate impacts with the model FUND than the Stern Review found with the model PAGE. We find that mitigation policies give even lower changes in BGE and argue that those policy choices should be the focus of the research effort rather than total damage estimates. According to our results, the current carbon tax should be below $55/tC. Sensitivity analyses show that the Stern Review chose parameters that imply high impact estimates. However, for regionally disaggregated welfare functions, we find changes in BGE that are significantly higher than the results from the Stern Review both for total damage as for policy analysis. With regional disaggregation and high risk aversion, we observe fat tails and with that very high welfare losses.      

An integrated tax-subsidy policy for carbon emission reduction

A carbon tax is often cited by economists as an effective instrument to mitigate greenhouse gas emissions, but there is little political interest in the United States. In light of this political unpopularity, we develop and examine a net-revenue constrained carbon tax and subsidy program. The optimal revenue constrained tax and subsidy schedule based on our utility maximization model taxes energy sources with high emissions to energy price ratio, and subsidizes sources with low emissions to energy price ratios. This approach may be more palatable than a traditional carbon tax because it can change the relative price of low and high emissions energy sources while providing a mechanism to limit net tax increases and energy price increases. We find that a constrained tax/subsidy program provides welfare gains relative to a no-tax scenario. Welfare gains are estimated to be 1% and 36% of the welfare gains from a Pigouvian tax for the motor fuels industry and electric power industry, respectively. In contrast, subsidies for low-emitting energy sources funded from general tax funds rather than from high-emission energy tax revenues lead to welfare decreases substantially below our proposed tax/subsidy policy approach.     

Profit-maximizing R&D in response to a random carbon tax

This paper determines a firm’s profit-maximizing R&D response to an uncertain carbon tax, for two different R&D programs: cost reduction of low carbon energy technologies and emissions reductions of currently economic technologies. We find that optimal R&D does not increase monotonically in a carbon tax. R&D into alternative technologies increases only if the firm is flexible enough; R&D into conventional technologies first increases then decreases in a carbon tax. Firms that are very flexible may increase R&D into alternative technologies when the uncertainty surrounding a carbon tax is increased; otherwise firms will generally decrease R&D investment in uncertainty.     

Using a Real‐Options Approach to Model Technology Adoption Under Carbon Price Uncertainty: An Application to the Australian Electricity Generation Sector*

The present climate for investment in electricity generation assets in Australia is uncertain. We develop a real‐options model to contrast the timing of the uptake of various electricity generation technologies under two carbon tax simulations: when a carbon tax of known size commences at a certain date in the future; and a carbon tax of known size commences at an uncertain date in the future. We find that uptake in the future varies significantly depending upon an investor's view of uncertainty and whether the technology is primarily designed to be viable in a market with or without carbon taxes.     

Tax Reform with Useful Public Expenditures

We examine the effects of tax reform in an endogenous growth with two types of useful public expenditures. The optimal fiscal policy shifts the tax base to private consumption and generally requires a change in the size of government. If a tax reform holds the size of government fixed to satisfy a revenue‐neutrality constraint, then the reform will be suboptimal; theory alone cannot tell us if welfare will be improved. For some model calibrations, we find that a revenue‐neutral consumption tax reform can result in large welfare gains. For other quite plausible calibrations, the exact same reform can result in tiny or even negative welfare gains as the revenue‐neutrality constraint becomes more severely binding. Overall, our results highlight the uncertainty surrounding the potential welfare benefits of fundamental tax reform.     

Environmental taxation and mergers in oligopoly markets with product differentiation

We analyze the effect of mergers on optimal environmental taxation in a Cournot oligopoly market with product differentiation. Our result indicates that the adjustment in emission tax crucially depends on the post-merger output distortion and pollution intensities. Specifically, we find that the optimal emission tax increases post-merger as long as pollution intensity of firms is higher and output distortion smaller post-merger than pre-merger. Furthermore, our result suggests that there is no need to revise environmental policy in markets where pollution intensity of firms does not change post-merger and (i) products are completely differentiated, or (ii) there are many firms for any degree of product differentiation.     

Global Warming and a Potential Tipping Point in the Atlantic Thermohaline Circulation: The Role of Risk Aversion

The risk of catastrophes is one of the greatest threats of climate change. Yet, conventional assumptions shared by many integrated assessment models such as DICE lead to the counterintuitive result that higher concern about climate change risks does not lead to stronger near-term abatement efforts. This paper examines whether this result still holds in a refined DICE model that employs the Epstein–Zin utility specification and that is fully coupled with a dynamic tipping point model describing the evolution of the Atlantic thermohaline circulation (THC). Risk is captured by the possibility of a future collapse of the circulation and it is nourished by fat-tailed uncertainty about climate sensitivity. This uncertainty is assumed to resolve in the middle of the second half of this century and the near-term abatement efforts, which are undertaken before that point of time, can be adjusted afterwards. These modelling choices allow posing the question of whether aversion to this specific tipping point risk has a significant effect on near-term policy efforts. The simulations, however, provide evidence that it has little effect. For the more likely climate sensitivity values, a collapse of the circulation would occur in the more distant future. In this case, acting after learning can prevent the catastrophe, implying the remarkable insensitivity of the near-term policy to risk aversion. For the rather unlikely and high climate sensitivity values, the expected damage costs are not great enough to justify taking very costly measures to safeguard the THC. Our simulations also provide some indication that risk aversion might have some effect on near-term policy, if inertia limiting the speed of decarbonisation is accounted for. As it is highly uncertain how restrictive this kind of inertia will be, future research might investigate the effects of risk aversion if additional uncertainty about inertia is considered.     

A 4-Stated DICE: Quantitatively Addressing Uncertainty Effects in Climate Change

We introduce a version of the DICE-2007 model designed for uncertainty analysis. DICE is a wide-spread deterministic integrated assessment model of climate change. Climate change, long-term economic development, and their interactions are highly uncertain. The quantitative analysis of optimal mitigation policy under uncertainty requires a recursive dynamic programming implementation of integrated assessment models. Such implementations are subject to the curse of dimensionality. Every increase in the dimension of the state space is paid for by a combination of (exponentially) increasing processor time, lower quality of the value or policy function approximations, and reductions of the uncertainty domain. The paper promotes a state-reduced, recursive dynamic programming implementation of the DICE-2007 model. We achieve the reduction by simplifying the carbon cycle and the temperature delay equations. We compare our model’s performance and that of the DICE model to the scientific AOGCM models emulated by MAGICC 6.0 and find that our simplified model performs equally well as the original DICE model. Our implementation solves the infinite planning horizon problem in an arbitrary time step. The paper is the first to carefully analyze the quality of the value function approximation using two different types of basis functions and systematically varying the dimension of the basis. We present the closed form, continuous time approximation to the exogenous (discretely and inductively defined) processes in DICE, and we present a numerically more efficient re-normalized Bellman equation that, in addition, can disentangle risk attitude from the propensity to smooth consumption over time.     

Optimal climate and fiscal policy in an OLG economy

This paper develops a climate–economy model to study the joint design of optimal climate and fiscal policies in economies with overlapping generations (OLGs). I demonstrate how capital taxation, if optimal, drives a wedge between the market costs of carbon (the net present value of marginal damages using the market interest rate) and the Pigouvian tax (the net present value of marginal damages using the consumption discount rate of successive OLGs). In contrast to deterministic infinitely lived representative agent models, at the optimum, the capital income tax is positive, the carbon price equals the market costs of carbon but it falls short of the Pigouvian tax when (i) preferences are not separable over consumption and leisure; and (ii) labor income taxes cannot be age-dependent. I also show that restrictions on climate change policy provide a novel rationale for positive capital income taxes.     

Higher Price,Lower Costs? Minimum Prices in the EU Emissions Trading Scheme

In this paper, we examine the introduction of a price floor in an emissions trading system (ETS) when some emissions are regulated outside the ETS. We theoretically characterize the conditions under which a price floor enhances welfare. Using a numerical simulation model of the European Union (EU), we find that moderate minimum prices in the EU ETS can reduce the costs of EU climate policy by up to 30 percent. We also find that, because of tax‐interaction effects, the optimal minimum price in the EU ETS should be about four times higher than the average marginal abatement cost in non‐ETS sectors.     

GROWTH,RENEWABLES, AND THE OPTIMAL CARBON TAX

Optimal climate policy is investigated in a Ramsey growth model of the global economy with exhaustible oil reserves, an infinitely elastic supply of renewables, stock‐dependent oil extraction costs, and convex climate damages. Four regimes can occur, depending on the initial social cost of oil being larger or smaller than that of renewables and depending on the initial oil stock being large or small. We also offer some policy simulations for the first and second regime, which illustrate that with a lower discount rate more oil is left in situ and renewables are phased in more quickly. We identify the conditions under which the optimal carbon tax rises or decreases. Subsidizing renewables (without a carbon tax) induces more oil to be left in situ and a quicker phasing in of renewables, but oil is depleted more rapidly initially. The net effect on global warming is ambiguous.     

When does a carbon tax on fossil fuels stimulate biofuels?

A carbon tax is an efficient economic instrument to reduce emissions of carbon dioxide released from fossil fuel burning. If designed properly, it could also help significantly to promote renewable energy. Using a multi-sector, multi-country computable general equilibrium model this study investigates under what circumstances a carbon tax would help stimulate penetration of biofuels into the energy supply mix for road transportation in various countries and regions around the world. This study shows that a carbon tax cum biofuel subsidy policy, where a carbon tax is introduced to fossil fuels and part of the tax revenue is used to finance the biofuel subsidy, would significantly help stimulate market penetration of biofuels. On the other hand, a carbon tax alone policy, where the entire tax revenue is recycled to households through a lump-sum transfer, does not help stimulate biofuels significantly even at higher tax rates. Although the carbon tax cum subsidy policy would cause higher loss in economic output at the global level as compared to the carbon tax alone policy, the incremental loss is relatively small. The key policy insight drawn from the study is that if a carbon tax were to be implemented in an economy for the purpose of climate change mitigation, recycling part of its revenue to finance biofuel subsidies would significantly help stimulate biofuels.     

Optimum Growth and Carbon Policies with Lags in the Climate System

We study the optimal carbon tax in an economy in which climate change, stemming from polluting non-renewable resource, affects the economy’s growth potential. Our main contribution is to introduce and explore the natural time lag of the climate system between emissions and damages to capital accumulation in an endogenous growth setting. This allows us to investigate how optimal climate policy, and its interplay with climate dynamics, affect long-run growth and the transition of the economy towards it. Without pollution decay, a higher speed of emissions diffusion steepens the growth profile of the economy. With pollution decay, this leads to lower short-run but higher long-run economic growth during transition. Poor understanding of the emissions diffusion process leads to suboptimal carbon taxes, resource extraction and growth.     

Numerical simulation on property tax reform: evidence from China

This article analyses the property tax reform in China in a computable general equilibrium model that recognizes the interaction between and among housing markets in different provinces and macroeconomic development. Using real data in 2010, we present the benchmark equilibrium for reference property and income tax rates. Then, we examine different property and income tax policies and make a comparison of their production, consumption, welfare and national income. We find that the implementation of property tax would decrease the house production at the expense of welfare in taxed area. The expansion of the taxed regions may increase the total social welfare and national income. Even though property tax policy may not be able to change the income distribution in China, increasing income tax rate could narrow the income disparity. Finally, this article shows the reliability of the conclusions when sensitivity analysis on optimal condition of equilibrium computation is performed under varied property tax policy.     

Climate change,fossil fuel prices and depletion: The rationale for a falling export tax

This paper examines how world prices affect depletion of exhaustible fossil fuels for export and the role of an export revenue tax in curbing depletion. Both effects are studied for a small open economy affected by climate change. We find that setting an export revenue tax rate to fall over time at the marginal social cost of depletion due to lower productivity from climate change encourages a resource exporter to leave an optimal stock in the ground – unextracted and unburnable. Growing prices during the past decade similarly curb depletion. Falling prices bring forward extraction. Because production is independent of consumption, the marginal social cost is independent of utility parameters which are difficult to estimate. Slowing fossil fuel extraction and the effective export of emissions is a contemporary challenge for climate policy. Our findings identify both why an export revenue tax should decline over time and an estimable target rate of decline to help meet this challenge amid changing world prices.     

Climate Policy under Technology Spillovers

We study climate policy when there are technology spillovers between countries, as there is no instrument that (directly) corrects for these externalities. Without an international climate agreement, the (non-cooperative) equilibrium depends on whether countries use tradable quotas or carbon taxes as their environmental policy instruments. All countries are better-off in the tax case than in the quota case. Two types of international climate agreements are then studied: One is a Kyoto type of agreement where each country is assigned a specific number of internationally tradable quotas. In the second type of agreement, a common carbon tax is used domestically in all countries. None of the cases satisfy the conditions for the social optimum. Even if the quota price is equal to the Pigovian level, R&D investments will be lower than what is socially optimal in the quota case. It is also argued that the quota agreement gives higher R&D expenditures and more abatement than the tax agreement.     

Optimal combination of innovation and environmental policies under technology licensing

Under what conditions will a carbon tax encourage environmental innovation? Can a regulator design an optimal environmental policy to reduce emissions and to promote clean technologies? This paper studies optimal environmental policy in the situation where a monopoly innovator develops and licenses clean production technologies to downstream polluting firms. We find that (i) a higher emission tax will encourage innovation when the burden of the tax payment in the polluters' costs and/or the price-elasticity of the demand for polluting goods are small, (ii) the innovation-inducing effects of emission tax are inversely related to the emission-reduction (Pigouvian) effects of the tax, and (iii) the social optimum can be achieved by the mix of tax and subsidy. We also show that if the policy instrument is limited to the tax, the second-best tax rate would lie between the marginal damage and the first-best rate. By performing numerical simulations, we also demonstrate that the optimal mix of the emission tax and R&D subsidy can have “double dividend” benefits.