state-contingentpricinganduncertaintyinclimatepolicy.docVIP

A Simple State-Contingent Pricing Policy for Complex Intertemporal Externalities( Ross McKitrickDepartment of EconomicsUniversity of Guelph rmckitri@uoguelph.ca August 2011 Abstract Uncertainties over the future path of global warming and the underlying severity of the problem make derivation of an intertemporally-optimal emissions price on carbon dioxide both theoretically and politically very difficult. A number of methods for dealing with uncertainty have dominated the economics literature to date. These involve trying to derive an emissions price or insurance premium to which agents are expected to make a long term commitment. This chapter explores an alternative approach based the concept of state-contingent pricing, in which agents commit to a pricing rule rather than a path. The rule connects current values of the emissions price to observed temperatures at each point in time. In essence, if the climate warms, the tax goes up, and vice versa. A derivation is provided showing how such a rule yields an approximation to the unknown optimal dynamic externality tax, yet can be computed using currently-observable data. A recently-proposed extension coupling the state-contingent tax with a tradable futures market in emission allowances would yield not only a feasible mechanism for guiding long term investment, but an objective prediction market for climate change. The advantage of the state-contingent approach for facilitating coalition-formation is also discussed, as are directions for research. A Simple State-Contingent Pricing Policy for Complex Intertemporal Externalities  Introduction Suppose we have a time machine that allows us to visit the year 2040 just long enough to collect some climate data. Figure 1 shows the post-1979 globally-averaged lower tropospheric air temperature anomaly averaged over the two satellite series developed by, respectively, Spencer and Christy (1990) and Mears and Wentz (2005). This is only one of many data series