Climate Policy and Catastrophic Change: Be Prepared and Avert Risk

The optimal reaction to a pending climate catastrophe is to accumulate capital to be better prepared for the disaster and levy a carbon tax to reduce the risk of the hazard by curbing global warming. The optimal carbon tax consists of the present value of marginal damages, the non-marginal expected change in welfare caused by a marginal higher risk of catastrophe, and the expected loss in after-catastrophe welfare. The last two terms offset precautionary capital accumulation. A linear hazard function calibrated to an expected time of 15 years for a 32% drop in global GDP if temperature stays at 6 degrees Celsius implies with a discount rate of 1.4% a precautionary return of 1.6% and a carbon tax of 136 US $/tC. More intertemporal substitution lowers precautionary capital accumulation and lessens the need for a high carbon tax, but implies less intergenerational inequality aversion which pushes up the carbon tax.