Strategic carbon taxation and energy pricing under the threat of climate tipping events

Abstract

An appropriate design of climate mitigation policies such as carbon taxes may face a lot of challenges in reality, e.g., the strategic behavior of fossil fuel producers, and huge uncertainty surrounding the climate system. This paper investigated the effect of possible climate tipping events on optimal carbon taxation and energy pricing, taking into account the strategic behavior of energy consumers/producers and the uncertainty of tipping points through a stochastic dynamic game. The game was solved numerically to get some insights into the equilibrium carbon taxation and energy pricing strategies under the threat of possible tipping events. The results suggest that the sudden occurrence of tipping events will shift the carbon tax upwards but shift the (wellhead) fuel price downwards, which generates an overall effect of a sudden increase in the consumer price. The irreversibility of the damage caused by a tipping point implies more aggressive carbon taxation. Moreover, the design of climate policy should adjust to tipping probabilities, damage uncertainty, and types of tipping events.