Climate Value at Risk: A Model Calibration Approach to Green Financing, Environmental Taxes, and Climate Change

Abstract

Climate change has the potential to slow economic growth by directly affecting capital depreciation and the level of output for a given set of inputs. Although several structural models have been developed to explore climate-economy dynamics, recent developments in green financing and environmental taxation have not been fully integrated into these frameworks. This paper explores how extending the Dynamic Integrated Climate-Economy (DICE) mode to incorporate the effects of cheaper green financing and environmental taxes on green investment can influence projected economic outcomes under various climate scenarios. We perform two empirical exercises to (i) illustrate that climate damages are unlikely to be priced into future dividends through rolling Fama-French regressions and (ii) quantify the effects of China's 2018 Environmental Protection Tax on green investment using a difference-in-difference approach. After calibrating our extended DICE model using existing parameters from the literature and our difference-in-difference estimates, our simulations suggest that while increased green investment can mitigate some climate risks, significant reductions in carbon emissions are needed to reduce the likelihood of catastrophic climate damages. We find that limiting warming to 2°C by 2100 increases the expected present value of global financial assets by 6.24% and the 99th percentile present value by 8.41% relative to a business-as-usual emissions path. Risk-neutral investors have a financial incentive to lower carbon emissions — and this is especially true for the risk-averse.