Integrating behavioural economics into climate-economy models: some policy lessons

Various macroeconomic models have been proposed to study the effects of climate policies. But from many corners now, it has been argued that these models are inadequate as tools for policy analysis. In particular, extreme impacts of climate change, inherent uncertainty, and discounting have been widely discussed as flaws of current models. Surprisingly, unrealistic assumptions about individual behaviour, which ignore well-documented behavioural ‘anomalies’ and social interactions, have attracted little attention so far in the economic analysis of climate change impacts and policies. This article begins to address this gap by providing an overview of formal macro-behavioural models, designed to incorporate a variety of realistic behaviours, such as present bias, habit formation, loss-aversion, and social status into economic theory. We show that ignoring behavioural anomalies may undermine the effectiveness of climate policies, which we illustrate with examples of optimal pollution tax and the social cost of carbon. In addition, we study the probability of the rebound effect in each behavioural model. The rebound effect describes a situation where improvements in energy efficiency render a reduction in energy consumption less than proportional. We show that status concerns make the economy more conducive to the rebound effect compared to a model with fully rational agents. Models of habit formation and loss aversion can have the opposite effect.POLICY RELEVANCECurrent models to assess climate policies may deliver biased insights owing to the omission of essential aspects of bounded rationality. The discounted utility framework, which describes how consumers trade current versus future consumption, is typically used to evaluate climate policies. Climate change economists have largely ignored alternative behavioural models, which integrate into economic theory realistic behaviours, such as: present bias, habit formation, loss-aversion, and social status. This is surprising in the light of evidence that virtually every assumption underlying the discounted utility model has been tested and found to be an invalid description of how people actually behave. We show with examples how well-established anomalies can undermine the effectiveness of climate policies.