Asset pricing and the carbon beta of externalities

Climate policy needs to set incentives for investors who face imperfect, distorted markets and large uncertainties about the costs and benefits of abatement. These investors decide on uncertain investments according to their expected return and risk (carbon beta). We study carbon pricing and financial incentives in a consumption-based asset pricing model distorted by technology spillovers and time-inconsistency. We find that both distortions reduce the equilibrium asset return and delay investment in abatement. However, their effect on the carbon beta and the risk premium for abatement can be decreasing (when innovation spillovers are not anticipated) or increasing (when climate policy is not credible). We show that the distortions can be overcome by modified carbon pricing by a regulator, or by financial incentives, implemented in our model by a long-term investment fund. The fund pays a subsidy to reduce technology costs or offers financial contracts to boost investment returns to complement the carbon price. The investment fund can thus pave the way for carbon pricing in later periods by preventing a capital misallocation that would be too expensive to correct, thus improving the feasibility of ambitious carbon pricing.