Catastrophic Damages and the Optimal Carbon Tax Under Loss Aversion

Recently, economists have begun to incorporate tipping points and catastrophic events into economy-climate models. It has been shown that the inclusion of tipping points amplifies the economic impacts of climate change and leads to much higher estimates of the social cost of carbon compared to the model that includes only non-catastrophic damages. All the estimates under catastrophic damages come from studies that assume full rationality. However, there is ample evidence that consumers exhibit loss aversion, meaning that they feel losses more strongly than equivalent gains. In this paper, we derive the optimal carbon tax in the Ramsey model under loss aversion and tipping points. We calibrate the model to generate a similar rate of return on capital, and thus pathways of capital and consumption, as a model with rational consumers in the business-as-usual scenario. We find that such a calibrated model generates an optimal carbon tax that is about three times higher than in the model with rational consumers in the optimal (OPT) scenario. A catastrophic event, which reduces the productivity of capital, results in a greater utility loss of loss-averse consumers compared to rational consumers. The optimal tax makes loss-averse consumers increase their precautionary savings before the shock, smoothing their consumption, which reduces welfare loss after the catastrophic event.