Limiting warming below 2°C slashes oil valuations by one-quarter.

6.3. First best: Immediate implementation of carbon tax to keep global warming below 2°C

To limit global warming and curb demand for fossil fuel, the government can impose a carbon tax which limits cumulative emissions to 300 GtC. Cost-efficient policy immediately implements a carbon tax of $180 per tC ($ 49 per tCO2) which grows exponentially at a rate equal to the market rate of interest (4% per year) until fossil fuel is priced out of the market in 50 years’ time. 20 After the end of the fossil era only a maintenance tax is required which moves in tandem with the cost for renewable and fossil energy, maintaining a wedge such that fossil fuel remains uncompetitive despite any occasional discoveries in oil and gas reserves which might occur in the future. This forceful pricing of carbon shifts downward the demand for fossil fuel and the extraction trajectory in Figure 2 (green, long-dashed). As a result, investment in exploration capital grinds to a halt, lowering the stock of exploration capital and the rate of new discoveries. Once the oil and gas companies have adjusted to the new policy environment, exploration investment briefly resumes to provide new discoveries which keep extraction costs at optimally low levels. This plateauing of discoveries at 4 GtC per year only last a brief period as the carbon budget is nearly used up and, anticipating the end of its business, the oil and gas companies slowly wind down capital and reserves before they finally close shop. A total of 170 GtC and $1.3 trillion of natural and physical assets are abandoned (stranded assets effect 1 and 2). Carbon pricing and its intended consequence of lower cumulative use immediately bite into the scarcity rent on existing reserves (which falls by 22 percent to $192). This drop of $53 per tC is more than compensated by the carbon tax of $180 per tC and demand falls. The current value of oil and gas companies drops by $7 trillion or 25% to $22 trillion under the first-best carbon tax (stranded asset effect 3).