Six Types of Ambiguity in a Ramsey Climate Policy Model

Abstract

While the scientific community is in general agreement about the nature and threat of global warming, the public and many political leaders are not. This paper casts the lack of full agreement as an instance of belief heterogeneity giving rise to six potential types of ambiguity with differing implications for carbon taxation and fiscal policy. Treating the Ramsey planner as a Stackelberg leader and private agents as followers, I distinguish three types of policy regime: (i) a political regime that strategically adopts the private sector's beliefs, (ii) a paternalistic regime that trust its own model only, and (iii) a pessimistic government with its own doubts about the climate model. The beliefs of private agents are represented by martingale multiplier perturbations M to a common approximating probability function and may be of two kinds: for pessimists}, M is a device to construct robust Euler conditions; for optimists, M is arbitrary and unknown to the planner, hence a source of ambiguity. The six proposed types of ambiguity differ in what the planner is ambiguous about, what private agents and the government know, and what the government believes private beliefs to be. In all instances, ambiguity induces robustness in policy and/or private decision rules affecting the social cost of carbon, and carbon and capital taxation. This paper shows further that, crucially, the carbon tax is not independent of other elements in fiscal policy. The results are framed in terms of distorted Arrow-Debreu pricing theory to show that the optimal carbon tax is equivalent to the permit price of an underlying asset---the government-imposed limit on emissions in economies with cap and trade.