Carbon taxes to avert climate disaster

Climate policies to reduce risks and make all generations better off

A new research report identifies carbon-risk tax policies that leave the welfare of current generations unchanged, raise the welfare of future generations by as much as 4% and lower the probability of a climate disaster from 9% to 1%. A key aspect of these taxes is that they need to start off at a high level and increase to even higher levels in the event of a series of bad shocks.

The study by Laurence Kotlikoff (Boston University), Felix Kubler (University of Zurich), Andrey Polbin (Russian Presidential Academy of National Economy and Public Administration) and Simon Scheidegger (University of Lausanne) also establishes a largely overlooked, but critical point about climate policy. Its most important role is to insure future generations against downside carbon risk.

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On 24 September 2018, the environmental activist, Greta Thunberg, addressed the United Nations with the following words: ‘You are failing us, but the young people are starting to understand your betrayal. The eyes of all future generations are upon you, and if you choose to fail us, I say, we will never forgive you.’

Ms Thunberg was right, the authors of this study say: by burning fossil fuels, current generations are changing the climate and thereby placing future generations at grave risk. Risk is the key word. There is significant uncertainty about the path of global warming and the magnitude and geographical location of its damages. These damages are projected as being positive on average and, indeed, potentially catastrophic.

Climate sceptics argue that climate uncertainty undermines the economic argument for an immediate reduction in the use of fossil fuels. The opposite, as this study shows, is true. Even were expected net carbon damage (damage, on average) to be zero, the downside risk of climate change is far too great to ignore. As the researchers show, the optimal carbon-risk tax – the tax needed to insure against downside climate risk – can be substantial.

The analysis appears to be the first study of optimal carbon-risk tax policy in a large-scale OLG model with substantial uncertainty with respect to both the climate system and the macroeconomy. Without uncertainty, the model produces only tiny damages to output, and taxation of carbon has small effects on welfare. The addition of uncertainty gives the potential for climate disasters, which the researchers define as a reduction in aggregate consumption greater than one-third relative to trend.

They analyse this uncertainty by assuming that in each period, three independent ‘shocks’ arise:

  • A shock that determines whether the economy will use more or less dirty energy.
  • A shock that exacerbates or mitigates the relationship between carbon dioxide emissions and temperature.
  • A ‘tipping-point’ shock that enlarges or shrinks a key parameter governing high carbon-concentration damages.

Although these shocks all have zero expectation, thanks to the model’s non-linearities, they can greatly increase the likelihood and extent of climate disasters. In the study’s main calibration with the three sources of risk activated, the probability, as of time zero, of a climate disaster arising over the next 250 years exceeds 7%. It exceeds 9% over the next 500 years.

The study’s key goal is to identify paths of carbon-risk taxes that substantially decrease the possibility of climate disasters while making all current and future generations better off. Since generations are finitely lived, current generations need to be compensated to ensure that carbon-risk taxation is ‘Pareto-improving’.

The authors identify carbon-risk tax policies that leave the welfare of current generations unchanged, raise the welfare of future generations by as much as 4% and lower the probability of a climate disaster from 9% to 1%. A key aspect of these taxes is that they need to start off at a high level and increase to even higher levels in the event of a series of bad shocks.

The research also establishes a largely overlooked, but critical point about climate policy. Its most important role is insure future generations against downside carbon risk.

‘Pareto-improving carbon-risk taxation’

Authors:

Laurence Kotlikoff (Department of Economics, Boston University, National Bureau of Economic Research and the Gaidar Institute, Russia)

Felix Kubler (Institute for Banking and Finance, The University of Zurich, Switzerland and The Swiss Finance Institute)

Andrey Polbin (Russian Presidential Academy of National Economy and Public Administration and the Gaidar Institute, Russia)

Simon Scheidegger (Department of Finance, University of Lausanne, Switzerland)