The Carbon Bubble: Climate Policy in a Fire-sale Model of Deleveraging

Credible implementation of climate change policy, consistent with the 2oC limit, requires a large proportion of current fossil fuel reserves to remain unused. This issue, named the Carbon Bubble, is usually presented as a required asset write-off, with implications for investors. For the first time, we discuss its implications for macroeconomic policy and for climate policy itself. We embed the Carbon Bubble in a macroeconomic model exhibiting a financial accelerator: if investors are leveraged, the Carbon Bubble may precipitate a fire-sale of assets across the economy, and generate a large and persistent fall in output and investment. We find a role for policy in mitigating the Carbon Bubble.