Risk and Aversion in Assessing Climate Policy

Abstract

The precise consequences of climate change remain uncertain. We incorporate damage uncertainty into a joint model of climate and the economy, an integrated assessment model. First, both the science and the integrated assessment community analyze uncertainty by means of sensitivity analysis and Monte-Carlo simulations. These methods have serious limitations in deriving a carbon tax or cap under uncertainty: they do not incorporate the interaction between stochastic climate impacts and economic policy. We derive the optimal climate policies accounting for the full interaction between uncertain damage realizations, optimal policy response, and climatic feedback. Second, state of the art integrated assessment relies on the standard economic model. Modern decision theory and its applications to finance show that this discounted expected utility model is incapable of simultaneously capturing adequate risk premia and a reasonable discount rate, leading to the equity premium and the risk-free rate puzzles. We follow the finance literature in disentangling risk aversion from the propensity to smooth consumption over time, which gives rise to a model reflecting correctly the risk-free discount rate and the risk premia. We find that optimal mitigation efforts are twice as high in the comprehensive risk model as compared to the entangled standard model.

Keywords: climate change policy, damages, uncertainty, integrated assessment, risk aversion

JEL Classification: Q54, Q00, D90, C63