Three reasons to price carbon under uncertainty: Accuracy of simple rules

Abstract

An easy-to-interpret rule for the optimal risk-adjusted social cost of carbon is derived using perturbation analysis. This rule internalises the adverse effects of global warming on the risk of recurring climate-related disasters and the risk of irreversible climate tipping points as well as the usual adverse effect on total factor productivity. It approximates the true numerical optimum very well, especially if the small parameters (i.e., the share of damages in GDP, the sensitivity of the risk of disasters to temperature and the risk of climate tipping) are small enough and the discount rates corrected for growth and risk is not too small. The rule is also accurate with ongoing technical progress in fossil-fuel production and multiple economic sectors even though the rule is derived for a one-sector model without such technical progress.

Keywords: carbon pricing; damages; recurring macroeconomic and climate-related disasters; climate tipping point; perturbation analysis.

JEL Classification: H21, Q51, Q54