Abstract

Abstract: We develop a dynamic model where heterogeneous firms take investment decisions depending on their beliefs on future carbon prices. A policy-maker announces a forward-looking tax schedule but can default on its plans if perceived transition risks are high, thus affecting its credibility in running climate policy. We show that (i) weak climate policy commitment can lead to the emergence of a ‘high-carbon trap’, especially in front of ambitious announcements; (ii) the presence of behavioural frictions – both in capital investment choices and in the assessment of the policy-maker’s credibility – has strong non-linear effects on the transition dynamics. We identify conditions leading to a successful transition and provide a quantitative application for the EU economy.

Co-Authors: Francesco Lampertib, and Roberta Terranovab

Practical information