NEW YORK, NY – From California to the European Union to China, some of the world’s largest economies are using “cap and trade” policies to reduce harmful carbon dioxide emissions that are contributing to climate change. But while these efforts are successful, the international community will need to take more aggressive action to prevent dangerous climate change and meet the carbon reduction targets set by the Paris Agreement. Columbia Business School Professor Gernot Wagner offers a novel approach to carbon pricing with a model that treats carbon dioxide in the atmosphere like a risky financial asset – one with negative payoffs. Wagner’s model shows that instead of setting incremental goals, policymakers should set a high price for carbon dioxide emissions today – a price that decreases over time.
Professor Wagner’s research provides a model that suggests that CO2 emissions be treated like other financial assets, such as real estate. Just as flood insurance mitigates risk and protects against potential future financial losses for a seaside home, carbon pricing can be seen as insurance against the severe damages and economic disruptions caused by emissions. Wagner's predictive economic model indicates that instead of setting incremental goals, policymakers should take strong action to price CO2 emissions immediately, treating them as a risky financial asset to protect against severe future damage.
The paper, Carbon Dioxide as a Risky Asset, published in the journal Climatic Change, develops of a model called the Carbon Asset Pricing (CAP6) model, which finds that implementing high carbon pricing policies early on aligns with the carbon reduction targets set by the Paris Agreement. This approach emphasizes favorable future climate outcomes by establishing a high carbon price now that steadily decreases, prompting more aggressive climate actions today and technological innovation for cheaper solutions because of carbon’s high cost. The CAP6 model shows that treating carbon dioxide as a risky asset and implementing appropriate policies now can offset future impacts.
"Unchecked carbon dioxide emissions have caused severe long-term economic and environmental damage," said Professor Gernot Wagner, faculty director of the Climate Knowledge Initiative. "Treating carbon dioxide as a risky asset prices that long-term harm, motivating the private sector to move more quickly to change behavior and creates funding that can be used to mitigate climate change. Combining financial economic thinking with climate science makes it clear the world is running out of time to reduce carbon emissions, and that it’s time to raise the financial stakes of pollution."
Professor Wagner and his co-authors, University of Illinois Urbana-Champaign Ph.D. student Adam Michael Bauer and Professor Cristian Proistosescu, aimed to optimize carbon pricing and mitigation strategies by combining financial logic with climate science through the development of the CAP6 model. To build CAP6, researchers gathered data from over 120 empirical studies on carbon pricing and emissions abatement, 75 meta-analyses on climate risk and economic impacts, and the IPCC's sixth assessment report. The model treats climate policies as insurance against severe but unlikely events, applying economic principles for managing risky assets. They updated CAP6 using the Transient Climate Response to Cumulative Emissions (TCRE) to link carbon dioxide emissions to global temperature increases accurately. The researchers tested the model with various discount rates ranging from 1.5% to 3% to understand how different valuations of future costs and benefits would affect climate outcomes. Their research shows that starting with high carbon prices now is crucial to prevent severe future climate risks and meet international climate targets.
Additional Findings:
- Carbon Prices over the Long Term: The study found that starting with high carbon prices, which decrease over time as technology improves, is important. This approach helps to aggressively cut emissions early, reducing the risk of severe future climate impacts.
- Alternative Discount Rates: The study found that even if reducing carbon emissions is more expensive than expected, taking strong and early action on carbon pricing is essential. Policies that place higher discount rates of 2.5% or 3% make achieving climate targets unlikely, underscoring the importance of low discount rates in effective climate policy.
"Viewing climate change as a risk management issue highlights the urgent need for a low-carbon economy," explained Professor Wagner. "Our analysis shows that treating carbon emissions like a risky investment demands bold action now. Future research must focus on managing the risks of transitioning to zero emissions, ensuring proactive measures protect us from significant future economic and environmental damages."
To learn more about the cutting-edge research being conducted, please visit Columbia Business School.
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