Incomplete financial markets, the social cost of carbon and constrained efficient carbon pricing

• This paper examines constrained optimal carbon pricing in a general equilibrium model with incomplete asset markets. A carbon policy consists of state-dependent carbon taxes and a sharing rule for tax revenue recycling. • The social cost of carbon (SCC) is defined as the present value of the future marginal costs of additional CO2 emissions, discounted at (personalized) prices. • For the case of complete markets, we state simple, sufficient conditions that ensure that setting carbon taxes equal to the SCC results in a Pareto-efficient competitive equilibrium. When markets are incomplete, constrained Pareto-efficient carbon taxes generically differ from the SCC. • To examine the potential quantitative importance of these differences, we consideran Aiyagari-style model with a climate change externality. We prove that the deviations of constrained optimal carbon taxes from the SCC can be arbitrarily large. This paper examines constrained optimal carbon pricing in a general equilibrium model with incomplete asset markets. A carbon policy consists of state-dependent carbon taxes and a sharing rule for tax revenue recycling. The social cost of carbon (SCC) is defined as the present value of the future marginal costs of additional CO2 emissions, discounted at (personalized) prices. For the case of complete markets, we state simple, sufficient conditions that ensure that setting carbon taxes equal to the SCC results in a Pareto-efficient competitive equilibrium. When markets are incomplete, constrained Pareto-efficient carbon taxes generically differ from the SCC. To examine the potential quantitative importance of these differences, we consider an Aiyagari [1994]-style model with a climate change externality. We prove that (i) the SCC cannot be estimated from aggregate damage functions and market prices alone, and (ii) the deviations of constrained optimal carbon taxes from the SCC can be arbitrarily large.