Optimal climate change policies when governments cannot commit

Abstract

We analyse the optimal design of climate change policies when a government wants to encourage the private sector to undertake significant immediate investment in developing cleaner technologies, but the relevant carbon taxes (or other environmental policies) that would incentivise such investment by firms will be set in the future. We assume that the current government cannot commit to long-term carbon taxes, and so both it and the private sector face the possibility that the government in power in the future may give different (relative) weight to environmental damage costs. We show that this lack of commitment has a significant asymmetric effect: it increases the incentive of the current government to have the investment undertaken, but reduces the incentive of the private sector to invest. Consequently the current government may need to use additional policy instruments – such as R&D subsidies – to stimulate the required investment.