Climate Policy and Catastrophic Change: Averting Risk and Being Prepared

OxCarre paper: The essence of climate policy is how to prepare for catastrophic change and how to reduce the risk of such events occurring. We show within the context of the Ramsey growth model that the optimal reaction to a pending climate catastrophe is, on the one hand, to have a capital subsidy to encourage capital accumulation to be better prepared for when the disaster hits the global economy, and, on the other hand, a carbon tax to reduce the risk of the hazard occurring by curbing demand for fossil fuel and carbon emissions and reversing the increase in global warming in the business-as-usual scenario. The optimal carbon tax consists of the conventional Pigouvian present value of marginal damages, the non-marginal expected change in welfare caused by a marginal higher risk of catastrophe resulting from burning an additional unit of fossil fuel, and the expected loss in after-catastrophe welfare. The last two terms offset the precautionary increase in capital resulting from the capital subsidy. The results are illustrated with an integrated assessment model of the global economy. A linear hazard function calibrated to a 6.8% chance of a 30% drop in global GDP at 2324 GtC implies an eventual capital subsidy of 1.5% and a global carbon tax of 136 US $/tC.