European Economic Review , Vol. 132, p. Article 103642

Optimal Carbon Abatement in a Stochastic Equilibrium Model with Climate Change

There is much discussion in the literature about the resources society should commit to ameliorate the effects of climate change. The optimal greenhouse gas abatement strategy has a direct relation to the social cost of carbon (SCC) which measures the externalities incurred in emitting one ton of carbon dioxide into the atmosphere. This paper studies a dynamic stochastic general equilibrium model involving climate change which allows for a systematic analysis of the SCC. One special feature of the framework is that it considers feedback effects on the temperature dynamics. We compare two approaches to capture damaging effects of temperature on output (level vs. growth rate impact) and find that there are notable differences in the optimal abatement strategy and the SCC. We document that climate uncertainty delivers a major contribution to the social cost of carbon. In particular, different types of climate shocks amplify each other and give an additional boost to the social cost of carbon. We also analyze the effect of risk aversion and the elasticity of intertemporal substitution on the SCC.