Declining CO₂ price paths.

Abstract

Pricing greenhouse-gas (GHG) emissions involves making trade-offs between consumption today and unknown damages in the (distant) future. While decision making under risk and uncertainty is the forte of financial economics, important insights from pricing financial assets do not typically inform standard climate-economy models. Here, we introduce EZ-Climate, a simple recursive dynamic asset pricing model that allows for a calibration of the carbon dioxide ([Formula: see text]) price path based on probabilistic assumptions around climate damages. Atmospheric [Formula: see text] is the "asset" with a negative expected return. The economic model focuses on society's willingness to substitute consumption across time and across uncertain states of nature, enabled by an Epstein-Zin (EZ) specification that delinks preferences over risk from intertemporal substitution. In contrast to most modeled [Formula: see text] price paths, EZ-Climate suggests a high price today that is expected to decline over time as the "insurance" value of mitigation declines and technological change makes emissions cuts cheaper. Second, higher risk aversion increases both the [Formula: see text] price and the risk premium relative to expected damages. Lastly, our model suggests large costs associated with delays in pricing [Formula: see text] emissions. In our base case, delaying implementation by 1 y leads to annual consumption losses of over 2%, a cost that roughly increases with the square of time per additional year of delay. The model also makes clear how sensitive results are to key inputs.