The cost-efficiency carbon pricing puzzle

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 without uncertainty, the growth rate of this price should be equal to the interest rate. It is therefore a puzzle that many cost-efficiency IAM models yield carbon prices that increase at an average real growth rate above 7% per year, a very large return for traders of carbon assets. I explore whether uncertainties surrounding the development of green technologies could solve this puzzle. I show that future marginal abatement costs and aggregate consumption are positively correlated. This justifies doing less for climate change than in the safe case, implying a smaller initial carbon price, and an expected growth rate of carbon price that is larger than the interest rate. In the benchmark calibration of my model, I obtain an equilibrium interest rate around 1% and an expected growth rate of carbon price around 3.5%, yielding an optimal carbon price above 200 USD/tCO2 within the next few years. 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. I show that green investors should be compensated for this risk by a large risk premium embedded in the growth rate of expected carbon prices, rather than by a collar on carbon prices as often recommended.