Working Paper: CEPR ID: DP15919
Authors: Christian Gollier
Abstract: Any global temperature target must be translated into an intertemporal carbon budget and its associated cost-efficient carbon price schedule. Under the Hotelling’s rule, the growth rate of this price should be equal to the interest rate. It is therefore a puzzle that cost-efficiency IAM models yield carbon prices that increase at an average real growth rate around 7% per year. This carbon pricing puzzle suggests that their abatement trajectoriesare not intertemporally optimized, probably because of the political unacceptability of a high initial carbon price. Using an intertemporal asset pricing approach, I examine the impact of the uncertainties surrounding economic growth and abatement technologies on the dynamics of efficient carbon prices, interest rates and risk premia. I show that marginal abatement costs and aggregate consumption are positively correlated along the optimal abatement path, implying a positive carbon risk premium and an efficient growth rate of expected 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). I also show that the rigid carbon budget approach to cost-efficiency carbon pricing implies a large uncertainty surrounding the future carbon prices that support this constraint. In this model, green investors are compensated for this risk by a large risk premium embedded in the growth rate of expected carbon prices, not by a collar on carbon prices as often recommended.
Keywords: carbon budget; risk-adjusted; Hotelling's rule; green finance; climate beta
JEL Codes: Q54; D81; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| growth rate of expected carbon prices (O44) | risk-adjusted discount rate (H43) |
| uncertainties in economic growth and abatement technologies (O49) | dynamics of efficient carbon prices (Q31) |
| marginal abatement costs (Q52) | aggregate consumption (E20) |
| rigid carbon budget approach (H60) | uncertainty in future carbon prices (Q47) |
| uncertainty in future carbon prices (Q47) | risk premium in expected growth rate of carbon prices (Q47) |
| efficient growth rate of carbon prices (Q31) | interest rate (E43) |