The economics of climate change is characterized by many uncertain- ties, including climate dynamics, economic damages and potentially ir- reversible climate catastrophes. Using an optimal growth model of a fossil-fuel driven economy subject to a climate externality and potentially irreversible climatic events, this paper contributes to the understanding of how the risk of such events impacts on optimal fossil-fuel over time. Catastrophic events are modelled as irreversible abrupt changes in the underlying system dynamics. Our analytical results reveals the existence of three important eects concerning optimal fossil-fuel use; i) the exis- tence of such events will increase the present value of marginal damages which works to postpone extraction ii) the probability of an event occur- ring sometime in the future also lowers the value of using fossil-fuels in the future which creates incentives to use more of the resource today iii) if the probability of a regime shift increases in fossil-fuel use this creates incentives to further postpone usage. Depending on the specication of the hazard rate process, which of the above eects dominates and the as- sumptions made regarding the abundance of fossil-fuel reserves, optimal extraction may become either increasingly precautionary or aggressive as a result of including potentially catastrophic events in the model.
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Keywords: Catastrophic events, climate change, economic growth, hazard
Citation: Gars, J., Engström, G. 2015 Beijer Discussion Paper no. 250