The National Carbon Price and Welfare on Alternative Paths Towards Net Zero Emissions: Simple Versus Optimal Policy Rules

To study the economic and welfare consequences of alternative time paths towards net zero CO2e emissions, we develop a multi-sector dynamic computable general equilibrium model of an open economy with heterogeneity in abatement costs across sectors and firms and with adjustment costs in the adoption of abatement technologies and other types of investment. We measure the welfare costs of following the simple rules for emissions reduction observed in practice rather than the optimal national policy rule prescribed by economic theory. In an undistorted economy subject to a carbon budget, the theoretically optimal climate policy is a "Hotelling rule" where the carbon tax rate increases year by year at the real rate of interest. However, when some consumers are credit-constrained, it is optimal to deviate from the Hotelling rule and use carbon taxation to redistribute income towards poor hand-to-mouth consumers. Nevertheless, in aggregate terms very little welfare is lost by following a Hotelling rule or a linear emissions reduction path rather than the optimal time path for carbon taxes when climate policy is subject to a carbon budget. The optimal carbon tax path towards a simple end-point target for net zero emissions implies a much higher welfare cost per ton of accumulated GHG emissions than a policy constrained by a carbon budget.