The Risk-Adjusted Carbon Price

Jan 2018 | 203

Authors: Rick Van der Ploeg Ton S. Van den Bremer

A popular model of economy and climate change has logarithmic preferences and damages proportional to the carbon stock in which case the certainty-equivalent carbon price is optimal. We allow for different aversions to risk and intertemporal fluctuations, convex damages, uncertainties in economic growth, atmospheric carbon, climate sensitivity and damages, correlated risks, and distributions that are skewed in the longer run to capture climate feedbacks. We derive a non-certainty-equivalent rule for the carbon price, which incorporates precautionary, risk-insurance and risk-exposure, and climate beta effects to deal with future economic and climatic risks. We interpret these effects with a calibrated DSGE model.

JEL Codes: H21, Q51, Q54

Keywords: precaution, insurance, economic, climatic and damage uncertainties, skewness, mean reversion, climate betas, risk aversion, prudence, intergenerational inequality aversion, convex damages, DSGE

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