The Carbon Bubble: climate policy in a fire-sale model of deleveraging

Credible implementation of climate change policy, consistent with the 2 °C 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. We embed the Carbon Bubble in a macroeconomic model exhibiting a financial accelerator: if investors are leveraged, then the Carbon Bubble might precipitate a fire‐sale of assets across the economy, and generate a large and persistent fall in output and investment, impairing the economy's ability to invest in the zero carbon assets it needs to produce output in the post‐climate‐transition world. We find a role for macroeconomic policy protecting investors' balance sheets in mitigating the macroeconomic effects of the Carbon Bubble, and enhancing welfare.