Applying Asset Pricing Theory to Calibrate the Price of Climate Risk

In this paper, we explore the implications of these richer preference specifications for the Social Cost of Carbon (SCC), the expected discounted damage of each marginal ton of carbon emissions at an optimal emissions reductions pathway. We develop a simple discrete-time model in which the representative agent has an Epstein-Zin preference specification, and in which uncertainty about the effect of carbon emissions on global temperature and on eventual damages is gradually resolved over time. In our model the SCC is equal to the value of the carbon emissions price at any given point in time that maximizes the utility of the representative agent at that time. We embed a number of features including tail risk, the potential for technological change, and backstop technologies. When coupled with the potential for low-probability, high-impact outcomes, our calibration allows us to decompose the SCC into the expected damages and the risk-premium. In contrast to most modeled carbon price paths, our calibration suggests a high SCC today that is expected to decline over time. It also points to the importance of backstop technologies and, in contrast to standard specifications, to potentially very large deadweight costs of delay. We find, for example, that with damage distributions calibrated to an SCC of $40, a value associated with only a small risk premium, the deadweight loss in utility associated with delaying the implementation of optimal pricing by 15 years is equivalent to a 6% loss of consumption