Precautionary Principle, Robustness and Optimal Taxes for a Stock Pollutant with Multiplicative Risk

Abstract:     
The interest shown by policy makers and economists in the precautionary principle indicates the importance of model uncertainty in global warming policy. I show that through robust control, policy makers can implement the precautionary principle to regulate a stock pollutant, and I analyze its effect on expected steady state pollution taxes, stocks and welfare. The paper is broadly comprised of a theoretical part and an application to global warming policy. I find that: (1) an increase in either uncertainty about the model or risk about abatement cost increases expected steady state pollution taxes; (2) a robust policy is preferred for any level of model uncertainty and this preference increases for either higher model uncertainty or higher multiplicative risk and (3) the effect on expected steady state pollution taxes and stock of introducing model uncertainty is relatively small for high levels of model uncertainty. These results advocate using robust policies for a stock pollutant in the presence of model uncertainty.

Keywords: Global warming, Knightian uncertainty, Multiplicative disturbances, Pollution control, Precautionary principle, Robustness, Stochastic control

JEL Classification: C61, E61, H21, Q28

Accepted Paper Series