Optimal Carbon Offsets with Heterogeneous Regions

Abstract

We study optimal climate policy in a global economy where regions differ in wealth and vulnerability to climate change. Carbon emissions from production generate out- put losses - a negative climate externality - and a technology to absorb and offset these emissions is available to all regions. We investigate how inequality shapes the stance of the global climate policy and the schedule of net emissions across regions: emissions net of carbon offsets. We provide an aggregation result that shows that the model with regional heterogeneity can be cast into a representative region world economy with a different discount factor and damage function elasticity to net emissions. We use this result to show that (i) Requiring all regions to contribute equally to carbon offsets ex- acerbates inequality and, therefore, efficiency calls for a less aggressive climate policy with more emissions and less carbon offsetting than in a representative agent world; (ii) When carbon offsets are allowed to depend on wealth, a more aggressive climate policy is optimal; (iii) Any global net emissions target prescribes positive net emis- sions for poor regions and negative net emissions for wealthy ones, with the burden on the rich increasing with inequality. These results highlight that carbon offsets play a crucial role in designing global climate policy because they act as a redistribution tool across unequal regions.