Carbon pricing is designed to internalise three externalities resulting from global warming: (i) higher damages to total factor productivity; (ii) higher risk of rare, recurring macroeconomic disasters; and (iii) higher risk of an irreversible climatic tipping point. Perturbation analysis is used to derive tractable and intuitive rules for the approximate optimal carbon price from a DSGE model of global warming and the economy. Numerically this rule approximates the optimal carbon price very well. Furthermore, the rule also works well with more general production functions, time-varying technical progress, and multiple production sectors. Similar rules that allow for different temperature dynamics and damage uncertainty also perform well.
Joint work with Rick van der Ploeg and Ton van den Bremer