Believe me when I say green! Heterogeneous expectations and climate policy uncertainty

What do firms expect future carbon prices to be, and how do they formulate their expectations? One basis for decision-making is likely to be the climate pledges of policymakers. However, policy announcements trigger the desired behavioural changes only if individuals believe these will be followed by actual policy actions.

The authors of this paper model and analyse the dynamic interaction between heterogeneous (diverse) expectations, investment decisions and climate mitigation policymaking, examining how firms invest in low versus high carbon capital depending on their beliefs about future carbon prices. They show that weak policy commitment, especially when combined with ambitious emission mitigation announcements, can trap the economy into a vicious circle of credibility loss, carbon-intensive investments and increasing risk perceptions, ultimately leading to a failure of the low-carbon transition. They identify the conditions that would lead to a successful transition and provide a numerical application for the EU economy. The results offer valuable insights for designing and communicating effective climate policies.

Key points for decision-makers

• The authors develop a novel modelling approach that accounts for dynamic beliefs and policy uncertainty.
• The model incorporates an important real-world dimension: i.e. a policymaker who announces forward-looking climate objectives may then renegotiate them if the costs of decarbonisation are perceived to be excessively high.  
• They show that a ‘high-carbon credibility trap’ might emerge when an ambitious plan is announced by a weakly committed policymaker, locking the economic system in a vicious circle of carbon-intensive investment, increasing transition risks and policymakers’ credibility, eventually leading to transition failure.
• They also show that the presence of ‘behavioural frictions’ – i.e. restraining factors such as incomplete information or the inability to process information – either in capital investment choices or in the assessment of the policymaker’s credibility, makes it harder to achieve full decarbonisation. In fact, even when the economic system is directed towards a low-carbon equilibrium (e.g. under a fully committed policymaker), behavioural frictions affect the rapidity of the decarbonisation process.
• The findings show how the dynamics of expectations about future climate mitigation policies can significantly affect the effectiveness of the climate policies themselves. It is thus key for the policymaker to be aware of what these expectations are and their distribution; and to be able to orient them as desired.
• The results also warn policymakers of the risks of having both too little and too much ambition in their policy announcements, as excessively ambitious plans combined with less than full commitment to respect them might backfire and produce worse outcomes than a less ambitious policy announcement.

This working paper was updated in August 2023.