Discussion paper
DP20438 Should Carbon Taxes be Pre-Announced? On Irreversible Investment, Real Options and Carbon Taxes
Climate change and its two-way relation with economic activity is stochastic and so is therefore the optimal tax internalizing the climate externality. But with capital irreversibility a stochastic time path for carbon prices slows down the reallocation from brown to green sectors because waiting then acquires an option value. We show that it is optimal to pre-announce a time path for future carbon taxes, eliminating the option value of waiting at the cost of suboptimality of the pre-announced taxes at the time they apply. We analyse for how long carbon taxes should be pre-announced and which factors influence that timespan.
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