David Pothier, University of Vienna: The Soft Carbon Budget Problem
Abstract - How fast should emissions be reduced when future technological improvements are uncertain? We propose a model where firms pollute subject to emission caps. The government sets emission caps to avoid environmental damages that are incurred if aggregate emissions exceed a carbon budget. Firms can invest in a new production technology. The first-best emissions policy satisfies Hotelling's Rule: the marginal cost of cutting emissions grows at the risk-free rate. If firms' investment is unobservable and the government cannot commit to future emission caps, the government frontloads emission reductions to stimulate investment even though production technologies are certain to become cleaner over time.