The economics of climate change is characterized by many uncertainties, including climate dynamics, economic damages and potentially irreversible 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 effects concerning optimal fossil-fuel use; i) the existence of such events will increase the present value of marginal damages which works to postpone extraction ii) the probability of an event occurring 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 specification of the hazard rate process, which of the above effects dominates and the assumptions 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.
Keywords: Catastrophic events, climate change, economic growth, hazard
Engström, G., and J. Gars. 2015. Beijer Discussion Paper 250: Climatic tipping points and optimal fossil fuel use. Beijer Discussion Paper Series.DOWNLOAD PDF