Policy makers concerned with setting optimal values for carbon instruments to address climate change externalities often employ integrated assessment models (IAMs). While these
models differ on their assumptions of climate damage impacts, discounting and technology, they conform on their assumption of complete markets and a representative household. In the
face of global inequality and significant vulnerability of asset poor households, we relax the complete markets assumption and introduce a realistic degree of global household inequality.
In contrast to the representative agent framework, we find that a household’s position on the
global wealth distribution predicts the identity of their most-preferred carbon price. Specifically,
poor agents prefer strong public action against climate change to mitigate the risk for which
they are implicitly more vulnerable. We find the carbon tax fills the role of insurance, reducing
the volatility of future welfare. It is this role that drives the wedge between rich and poor
households’ policy preferences, even in the absence of redistribution. Taking into account the
risk channel, we find an optimal tax value four times larger than standard estimates from
representative agent models
