Conference Agenda

We show how carbon premiums and stranded assets may result from policy transition risks. More generally, we analyze asset pricing and climate policy in the face of transition and physical risks using a global DSGE model of climate and the economy, where consumption goods are produced by a green and a carbon-intensive sector and reallocation of capital is subject to intrasectoral adjustment costs. Physical risks consist of temperature-related risks of recurring climate-related disasters and the risks of irreversible climate tipping. Transition

risks consist of technological breakthroughs in negative emissions technologies and changes in policy regime with three states (business as usual, Pigouvian climate policy, and a temperature cap). We show how transition and physical risks affect the carbon price, the risk-free rate, the risk premiums of green and brown assets. Transition risks can trigger asset stranding if a government introduces a temperature cap and bans further carbon emissions. These risks are priced in and lead to sizable carbon risk premiums.

An easy-to-interpret rule for the optimal risk-adjusted social cost of carbon is derived using perturbation analysis. This rule internalises the adverse effects of global warming on the risk

of recurring climate-related disasters and the risk of irreversible climate tipping points as well as

the usual adverse effect on total factor productivity. It approximates the true numerical optimum

very well, especially if the small parameters (i.e., the share of damages in GDP, the sensitivity of the risk of disasters to temperature and the risk of climate tipping) are small enough and the discount rates corrected for growth and risk is not too small. The rule is also accurate with ongoing technical progress in fossil-fuel production and multiple economic sectors even though the rule is derived for a one-sector model without such technical progress.

Carbon prices in the EU emissions trading system (EU ETS) are a key instrument driving Europe’s decarbonization. Between 2017 and 2021, they surged tenfold, exceeding 80 €/tCO2 and reshaping investment decisions across the electricity and industry sectors. What has driven this increase is an open question. While it coincided with two significant reforms tightening the cap (“MSR reform” and “Fit for 55”), we argue that a reduced supply of allowances alone cannot fully explain the price rise. A further crucial aspect is that actors must have become more farsighted as the reform signaled policymakers’ credible long-term commitment to climate targets. This is consistent with model results that show historic prices can be better explained with myopic actors, while explaining prices after the reforms requires actors to be farsighted. To underline the role of credibility, we test what would happen if a crisis undermines policy credibility such that actors become myopic again, demonstrating that carbon prices could plummet and endanger the energy transition.

Modeling interactions between climate change, macroeconomy and Earth subsystems with non-linear, self-sustaining, stochastic and debated dynamics is a major challenge with important policy implications. We analytically derive the channels through which interactions between subsystem’s idiosyncratic risk and aggregate climate risk over intertemporal welfare affect global climate policy. We highlight how management of the subsystem at the regional scale might be shaped by an explicit reduced-form representation of its geophysical dynamics. We apply our framework in a calibrated quantitative model of the Amazon rainforest whose fate is fiercely debated.