The economic and policy consequences of carbon emissions

Abstract

Carbon emissions are increasingly being recognized as a threat to economic well-being. This paper incorporates the carbon cycle into a general equilibrium model to study the asset pricing implications of the interaction between carbon emissions and mitigation policies. Our findings suggest that the accumulation of carbon stocks stimulates mitigation spending, reduces consumption, harms welfare, lowers the risk-free rate, and elevates the risk premium. Furthermore, we propose a framework for policy analysis that includes calculating the social cost of carbon (SCC) and the willingness to pay (WTP). Additionally, results show the complex impacts of carbon dynamics on the risk-free rate. Specifically, higher carbon decay rates and the economic damage caused by carbon increase the risk-free rate, while carbon volatility risk lowers it. Moreover, convex damage functions can reverse the trend of the risk-free rate, causing it to rise with carbon stock.