Climate Policy in an Unequal World: Assessing the Cost of Risk on Vulnerable Households

Policy makers concerned with setting optimal values for carbon instruments to address climate change externalities often employ integrated assessment models (IAMs). While these models differ on their assumptions of climate damage impacts, discounting and technology, they conform on their assumption of complete markets and a representative household. In the face of global inequality and significant vulnerability of asset poor households, we relax the complete markets assumption and introduce a realistic degree of global household inequality. A simple experiment of introducing a range of global carbon taxes shows a household’s position on the global wealth distribution predicts the identity of their most-preferred carbon price. Specifically, poor agents prefer strong public action against climate change to mitigate the risk for which they are implicitly more vulnerable. This preference exists even without progressive redistribution of the revenue. We find that, parallel to the literature on macroeconomic policy and incomplete markets, the carbon tax can partially fill the role of insurance by reducing the volatility of future welfare. It is this role that drives the wedge between rich and poor households’ policy preferences, where rich households’ preferences closely mimic the representative agent. Estimates of the optimal carbon tax and the welfare gains of mitigation strategies may be underestimated if this channel is not taken into account.