Integrating behavioural economics into climate-economy models: some policy lessons

Various macroeconomic models have been proposed to study the effects of climate policies. But from many corners now, it has been argued that these models are inadequate as tools for policy analysis. In particular, extreme impacts of climate change, inherent uncertainty, and discounting have been widely discussed as flaws of current models. Surprisingly, unrealistic assumptions about individual behaviour, which ignore well-documented behavioural ‘anomalies’ and social interactions, have attracted little attention so far in the economic analysis of climate change impacts and policies. This paper begins to address this gap by providing an overview of formal macro-behavioural models, designed to incorporate a variety of realistic behaviours, such as present bias, habit formation, loss-aversion and social status into economic theory. We show that ignoring behavioural anomalies may undermine the effectiveness of climate policies, which we illustrate with examples of optimal pollution tax and the social cost of carbon. In addition, we study the probability of the rebound effect in each behavioural model. The rebound effect describes a situation where improvements in energy efficiency render a reduction in energy consumption less than proportional. We show that status concerns make the economy more conducive to the rebound effect compared to a model with fully rational agents. Models of habit formation and loss aversion can have the opposite effect.