Applying Asset Pricing Theory to Calibrate the Price of Climate Risk

Kent Daniel, Robert Litterman and Gernot Wagner

No 22795, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: Pricing greenhouse gas emissions involves making trade-offs between consumption today and unknown damages in the (distant) future. This setup calls for an optimal control model to determine the carbon dioxide (CO2) price. It also relies on society’s willingness to substitute consumption across time and across uncertain states of nature, the forte of Epstein-Zin preference specifications. We develop the EZ-Climate model, a simple discrete-time optimization model in which uncertainty about the effect of CO2 emissions on global temperature and on eventual damages is gradually resolved over time. We embed a number of features including potential tail risk, exogenous and endogenous technological change, and backstop technologies. The EZ-Climate model suggests a high optimal carbon price today that is expected to decline over time as uncertainty about the damages is resolved. It also points to the importance of backstop technologies and to very large deadweight costs of delay. We decompose the optimal carbon price into two components: expected discounted damages and the risk premium.

JEL-codes: G0 G12 Q51 Q54 (search for similar items in EconPapers)
Date: 2016-11
New Economics Papers: this item is included in nep-ene, nep-env and nep-upt
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Published as Daniel, Kent D., Robert B. Litterman, and Gernot Wagner. "Declining CO2 price paths," PNAS (1 October 2019). doi: 10.1073/pnas.1905755116.

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