Working papers (available for download from SSRN):
- The Social Cost of Carbon in a Non-Cooperative World (with Holger Kraft and Eduardo S. Schwartz), this paper replaces the earlier working paper called “The Carbon Abatement Game”, Winner of the Best Paper Award in Economics and Finance at IRMBAM-2019
ABSTRACT: The recent literature has derived simple formulas for the Social Cost of Carbon (SCC) that are easy to interpret, but that only apply to the global economy. This is an issue since international transfers to sustain the global optimum with the same carbon price for all countries are still lacking after thirty years of climate summits. The main research objective of our paper is to obtain tractable analytical and interpretable formulas for the SCC, the optimal carbon taxes, and the optimal consumption-abatement strategies in a non-cooperative world. We find that the optimal taxes are proportional to national GDP and can be decomposed into a domestic and a foreign component where the latter stems from trade. Besides, heterogeneity in country-specific damage functions together with the size of international trade can significantly affect the regional distribution of the SCC.
- Asset Pricing and Decarbonization: Diversification vs. Climate Action (with Holger Kraft and Frederick van der Ploeg)
ABSTRACT: Asset pricing and climate policy are analyzed in a global economy where consumption goods are produced by both a green and a carbon-intensive (dirty) sector. We allow for endogenous growth and three types of damages from global warming. It is shown that, initially, the desire to diversify assets in the portfolio complements the attempt to mitigate economic damages from climate change. In the long run, however, there is a trade-off between diversification and climate action. Therefore, in general, the carbon-intensive sector is not shut down completely. We derive the optimal carbon price, the equilibrium risk-free rate, and the risk premium of both assets. The risk-free rate is negatively affected by temperature, while the effect of temperature on the risk premiums depends on the type of damage specification. Climate disasters with an uncertain timing that rises with on temperature leads to a significant effect of climate change on asset prices.
- Optimal Carbon Abatement in a Stochastic Equilibrium Model with Climate Change (with Holger Kraft and Eduardo S. Schwartz)
ABSTRACT: This paper studies a dynamic stochastic general equilibrium model involving climate change. Our framework allows for feedback effects on the temperature dynamics. We are able to match estimates of future temperature distributions provided in the fifth assessment report of the IPCC (2014). We compare two approaches to capture damaging effects of temperature on output (level vs. growth rate impact) and combine them with two degrees of severity of this damage (Nordhaus vs. Weitzman calibration). It turns out that the choice of the damage function is crucial to answer the question of how much the distinction between level and growth rate impact matters. The social cost of carbon is similar for frameworks with level or growth rate impact if the potential damages of global warming are moderate. On the other hand, they are more than twice as large for a growth rate impact if damages are presumably severe. We also study the effect of varying risk aversion and elasticity of intertemporal substitution on our results. If damages are moderate for high temperatures, risk aversion only matters when climate change has a level impact on output, but the effects are relatively small. By contrast, the elasticity of intertemporal substitution has a significant effect for both level and growth rate impact. If damages are potentially severe for high temperatures, then the results also become sensitive to risk aversion for both damage specifications.
- Solving Life Cycle Problems with Biometric Risk by Artificial Insurance Markets (with Holger Kraft and Claus Munk)
ABSTRACT: We establish a powerful method to solve the life-cycle consumption choice problem of an individual facing biometric risks that are uninsurable. Problems of this type are notoriously hard to solve and closed-form solutions are unknown. The solution is obtained by optimizing over a parametrized family of consumption strategies. Each of these strategies is the optimal consumption strategy derived in closed form in an artificial market where the individual has access to fully flexible insurance contracts. In settings with mortality risk, critical illness risk and habit formation, our solution method outperforms the well-established finite difference approach both in running time and in precision. In contrast to the existing literature, our method also produces a closed-form consumption strategy, with some parameters determined in a numerical optimization.
- When Should Retirees Tap Their Home Equity? (with Holger Kraft and André Meyer-Wehmann)
ABSTRACT: This paper studies a household’s optimal demand for a reverse mortgage. These contracts allow homeowners to tap their home equity to finance consumption needs. In stylized frameworks, we show that the decision to enter a reverse mortgage is mainly driven by the differential between the aggregate appreciation of the house price and principal limiting factor on the one hand and the funding costs of a household on the other hand. We also study a rich life-cycle model that can explain the low demand for reverse mortgages as observed in US data. In this model, we analyze the optimal response of a household that is confronted with a health shock or financial disaster. If an agent suffers from an unexpected health shock, she reduces the risky portfolio share and is more likely to enter a reverse mortgage. On the other hand, if there is a large drop in the stock market, she keeps the risky portfolio share almost constant by buying additional shares of stock. Besides, the probability to take out a reverse mortgage is hardly affected.