Climate uncertainty, financial frictions and constrained efficient carbon taxation

TL;DR

This paper explores how financial frictions and cost-sharing schemes influence optimal carbon taxes and abatement levels in a heterogeneous agents model under climate uncertainty, revealing significant impacts on policy outcomes.

Contribution

It introduces a simple linear cost-sharing scheme for abatement costs and demonstrates how financial frictions can substantially alter optimal abatement levels.

Findings

Financial frictions can triple optimal abatement compared to frictionless markets.

Different cost-sharing schemes significantly affect abatement levels.

Incomplete markets increase the importance of equitable cost distribution.

Abstract

In this paper, I consider a simple heterogeneous agents model of a production economy with uncertain climate change and examine constrained efficient carbon taxation. If there are frictionless, complete financial markets, the simple model predicts a unique Pareto-optimal level of carbon taxes and abatement. In the presence of financial frictions, however, the optimal level of abatement cannot be defined without taking a stand on how abatement costs are distributed among individuals. I propose a simple linear cost-sharing scheme that has several desirable normative properties. I use calibrated examples of economies with incomplete financial markets and/or limited market participation to demonstrate that different schemes to share abatement costs can have large effects on optimal abatement levels and that the presence of financial frictions can increase optimal abatement by a factor of three relative to the case of frictionless financial market.