Applying Asset Pricing Theory to Calibrate the Price of Climate Risk

51 Pages Posted: 7 Nov 2016 Last revised: 23 Nov 2016

See all articles by Kent D. Daniel

Kent D. Daniel

Columbia Business School - Finance and Economics; National Bureau of Economic Research (NBER)

Bob Litterman

Goldman Sachs

Gernot Wagner

New York University (NYU) - Department of Environmental Studies; New York University (NYU) - Robert F. Wagner Graduate School of Public Service

Date Written: November 2016

Abstract

Pricing greenhouse gas emissions involves making trade-offs between consumption today and unknown damages in the (distant) future. This setup calls for an optimal control model to determine the carbon dioxide (CO2) price. It also relies on society’s willingness to substitute consumption across time and across uncertain states of nature, the forte of Epstein-Zin preference specifications.We develop the EZ-Climate model, a simple discrete-time optimization model in which uncertainty about the effect of CO2 emissions on global temperature and on eventual damages is gradually resolved over time. We embed a number of features including potential tail risk, exogenous and endogenous technological change, and backstop technologies.The EZ-Climate model suggests a high optimal carbon price today that is expected to decline over time as uncertainty about the damages is resolved. It also points to the importance of backstop technologies and to very large deadweight costs of delay. We decompose the optimal carbon price into two components: expected discounted damages and the risk premium.

Suggested Citation

Daniel, Kent D. and Litterman, Bob and Wagner, Gernot, Applying Asset Pricing Theory to Calibrate the Price of Climate Risk (November 2016). NBER Working Paper No. w22795, Available at SSRN: https://ssrn.com/abstract=2865533

Kent D. Daniel (Contact Author)

Columbia Business School - Finance and Economics ( email )

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National Bureau of Economic Research (NBER)

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Bob Litterman

Goldman Sachs ( email )

Gernot Wagner

New York University (NYU) - Department of Environmental Studies ( email )

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New York University (NYU) - Robert F. Wagner Graduate School of Public Service ( email )

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