Gollier, Christian (2022) The cost-efficiency carbon pricing puzzle. TSE Working Paper, n. 18-952, Toulouse

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Abstract

When an intertemporal carbon budget is imposed to fight climate change, carbon pricing must be simultaneously efficient to allocate efforts intertemporally and coherent with the prices of other assets in the economy. The expected carbon prices should therefore grow at the social discount rate, adjusted for the risk profile of marginal abatement costs(MAC). I calibrate a simple two-period version of the model by introducing infrequent macroeconomic catastrophes à la Barro in order to fit the model to observed assets pricing in the economy. I show that MAC and aggregate consumption are positively correlated, so that abating early does not hedge the macroeconomic risk, implying a growth rate of expected efficient carbon prices larger than the interest rate. From this numerical exercise, I recommend a growth rate of expected carbon price around 3.75% per year (plus inflation), which is much smaller than what is recommended by most climate models with a fixed carbon budget. This means that most climate models using a carbon budget largely underestimate the efficient carbon price in the short run. I also show that the rigid carbon budget approach to carbon pricing implies a very large uncertainty surrounding the future carbon prices that support this constraint.