Thomas S. LONTZEK
The 2021 Erik Kempe Award has been given to Yongyang CAI and Thomas S. LONTZEK for their article
The Social Cost of Carbon with Economic and Climate Risks
Journal of Political Economy 127, 2684-2734, 2019
Abstract.Uncertainty about future economic and climate conditions substantially affects the choice of policies for managing interactions between the climate and the economy. We develop a framework of dynamic stochastic integration of climate and economy, and show that the social cost of carbon is substantially affected by both economic and climate risks and is a stochastic process with significant variation. We examine a wide but plausible range of values for critical parameters with robust results and show that large-scale computing makes it possible to analyze policies in models substantially more complex and realistic than usually used in the literature.
The Nomination Committee, composed by Thomas Aronsson (chair), Simon Dietz, Katrin Millock, has awarded this paper for the following motivation:
Risk and uncertainty play key roles in the economics of climate change, both because economic choices are often subject to uncertainty and because the climate system contains its own uncertainties. However, the Integrated Assessment Models developed during recent decades to analyze economy-climate interaction as well as policy implications thereof are typically deterministic. The award-winning paper bridges this important gap. The paper develops an Integrated Assessment Model for a global economy through an extension of the DICE-model, called DSICE (dynamic stochastic integration of climate and the economy), which includes uncertainty both in the economic and climate components of the model. The paper also estimates the social cost of carbon (SCC), which in this framework is a stochastic process, and examines how this cost varies with parameters of the economic environment. The SCC measures the marginal value to society of removing carbon from the atmosphere and is the key ingredient of a first-best Pigouvian carbon tax.
The paper addresses the implications of uncertainty both in the economic and climate systems, and how these uncertainties are informative about the SCC. To account for uncertainty in the economic system, the authors add a stochastic component to productivity growth, allowing them to examine how uncertainty about productivity ought to influence climate change policies through its impact on the SCC. While the mean path of the SCC is often relatively close to paths implied by deterministic models, the authors also find that the process displays substantial variance. For instance, while the median SCC in the baseline simulation is $286/tC in the year 2100, there is a 10 percent chance of exceeding $700/tC and 1 percent chance of exceeding $1200/tC. In general, the standard deviation of the SCC grows faster than the mean. Thus, the analysis goes much beyond conventional models in this area. In addition, the authors include tipping elements in the climate component of the model, i.e., transitions to irreversible climate processes. The results show, among other things, that the threat of a tipping element leads to an immediate and significant increase in the SCC. In fact, the SCC can be very high in plausible examples of uncertain and irreversible climate change. This creates incentives to reduce the tipping probability and to delay or cancel potential tipping events through more abatement effort and/or higher carbon taxation. If a tipping event occurs, this incentive disappears and the SCC will drop down significantly.
Yongyang Cai and Thomas S. Lontzek receive the Erik Kempe Award for a novel and insightful contribution to the development of Integrated Assessment Models by adding uncertainty about economic and climate conditions. First, the authors develop a computable dynamic general equilibrium model of a global economy, which simultaneously accounts for several types of uncertainty. The treatment of uncertainty in an Integrated Assessment Model is itself a significant contribution to environmental economics. Solving the highly complex model is also a contribution to computational economics. Second, by using the model to analyze the SCC a number of important insights emerge, which are of direct relevance for climate policy. Finally, the general equilibrium framework developed by the authors has applications also beyond those presented in the paper. In other words, Cai and Lontzek have extended the modelling framework for studying economy-climate interactions in a very useful way as well as presented implications of clear practical relevance for climate policy.