Pareto-improving climate policy with heterogeneous abatement costs in the building sector

We build a dynamic model in which home owners decide when and how to switch to carbon-neutral heating. Agents differ with regard to carbon intensity and abatement costs, the latter being private information which is non-observable by the government. The heating-related investment model is nested in an overlapping generations Mirrlesian optimal taxation model with heterogeneous home ownership and labor productivity. We develop a compensation mechanism which guarantees a weak Pareto-improvement for every agent when aggregate benefits of climate policy exceed aggregate costs. The mechanism includes carbon pricing with category-based transfers, uniform ad-valorem subsidies on investments that are financed by public debt, and an income tax adjustment based on climate mitigation benefits, used to service debt. We show that exact compensation of homeowners’ dynamic abatement cost requires only minimal information: the interest rate and the future fossil fuel price path. By means of exact compensation, our model utilizes the income-tax system to redistribute heterogeneous transformation costs between households according to any number of normative considerations without efficiency losses. We numerically illustrate subsidy rates and income tax adjustments for Germany.