Abstract: The economics of climate change is characterized by many uncertainties, including climate dynamics, economic damages and potentially irreversible climate catastrophes. Using an optimal growth framework to model a fossil fuel driven economy subject to climate externalities and potentially irreversible climatic events or damages, this paper makes contributions to the understanding of how the probability of such events impacts on optimal fossil fuel use over time. Catastrophic events are modeled as irreversible abrupt changes in the underlying system dynamics such as the climate damage or carbon cycle parameters. Our analytical results reveal three important effects; i) the existence of a potential regime shift implies an increase in the present value of marginal damages and hence creates incentives to postpone current fossil fuel use to the future ii) the probability of an event occurring sometime in the future, lowers the value of future fossil fuel use from that point on and thus creates incentives to use more of the resource today (a Hotelling type effect) iii) with the probability of a regime shift increasing in fossil fuel use this creates incentives to postpone fossil fuel use. Depending on whether an event occurs with a constant or endogenous probability, our results show that the impact of a potential climate catastrophe can cause optimal fossil fuel management to range from precautionary, ambiguous but even aggressive depending on whether fossil fuel reserves are assumed to be scarce or abundant.
Citation: Gars, J. and G. Engström 2014. Optimal policy under potential regime shifts and resource scarcity in the economics of climate change. Fifth World Congress of Environmental and Resource Economists Istanbul, Turkey