Setting Carbon Taxes using Declining Discount Rates: Implications for Investment-Based Mitigation Available to Purchase

The use of declining discount rates (DDR) to calculate the net present value of damages associated with climate change has important ramifications for climate policy. We examine the behavior of a firm subject to climate-based market interventions, specifically carbon taxes or abatement credits that are indexed to the social cost of carbon (SCC). Recognizing that private abatement investment decisions are financed via capital markets, we show that when the SCC is calculated using a DDR it is impossible for the policymaker to induce a level of investment today that is consistent with the SCC forecast for future periods. This leads to significant under-investment in abatement. We discuss the practical implications of this result for climate policy, with particular focus on climate policies designed to foster investment-based mitigation.