Capital Malleability and its Implications for Climate Policy Design

Integrated assessment models are widely used in economic analysis for deriving best-response policies to the threat of anthropogenic climate change. In this paper, we investigate how the degree of capital malleability influences the optimal climate policy design for alternative assumptions on climate damages and the timing of net-zero emissions policies. We compare a putty-putty setting, where capital is malleable both ex-ante and ex-post of investment decisions with a putty-clay setting where capital intensity cannot be changed ex-post. We find that optimal policy responses differ substantially as the short-term pressure for emissions abatement increases (i.e., climate damages are sufficiently high) or if there is uncertainty on the timing of a net-zero policy. With high climate damages, putty-clay requires much stronger emission intensity improvements than suggested by putty-putty due to the inertia of capital vintages. This must be reflected in command-and-control strategies when straight carbon pricing at the social cost of carbon is not feasible. We also show that hedging against policy uncertainty â€" such as the timing of net-zero emissions â€" can create substantial differences in the optimal abatement path between putty-putty and putty-clay.

Thomas Rutherford is an applied economist working on issues in trade, energy and environmental economics.

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