The Opportunity Cost of Climate Policy: A Question of Reference*

Abstract

AbstractThe cost of climate policy depends on the no‐policy alternative without which the “opportunity cost” of climate action cannot be determined. This baseline path has to reflect the current failure in the market for carbon emissions. Because of a negative externality, private investment decisions are made without considering the climate damage they entail. Agents overinvest in conventional capital and underinvest in climate capital. Internalization of climate damage lowers the private return to capital, and agents reduce investment in favor of mitigation and consumption. Optimal climate policy increases the welfare of both the present and the future. A simulation of the inefficient no‐policy scenario in the Dynamic Integrated Climate–Economy model (DICE‐07) confirms this numerically.