Irreversibility and Optimal Timing of Climate Policy

Abstract

We focus on the optimal timing of climate change mitigation policies, a decision which is complicated by multiple sources of irreversibility or inertia. The pertinence of Real Option Theory in understanding the optimal amount of necessary precautionary behavior is explored, as are the results from modeling exercises. Generally, it appears that irreversibility associated with sunk abatement capital is stronger than that from accumulating greenhouse gas emissions, implying an option value to delaying climate change mitigation. The inclusion of tipping points, or non-linearities in environmental damages, could nevertheless lead to the opposite conclusion. These effects are however not easily quantifiable and are not generally included in modeling exercises. The timing decision will therefore have to be made by policy makers after having subjectively evaluated the importance of potential tipping points. It is for this reason that policy-makers need to be able to themselves understand the intuition behind Real Option theory - the interplay between irreversibility and uncertainty. Many climate-economic modeling exercises have implicitly recognized this fact by integrating strict environmental targets which serve as hard constraints and represent precautionary behavior.