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Optimal Discount Rates for Investments in Mitigation and Adaptation

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  • Rob Aalbers

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    Abstract

    This paper develops a theory of asset pricing in which discount rates for investments in all assets, including adaptation and mitigation, are endogenously determined. Exploiting the characteristics of adaptation and mitigation in terms of climatic risk, I show that adaptation requires a lower discount rate, whereas mitigation does not. Inspection of the Ramsey rule reveals that the social discount rate equals the social rate of return on optimally-invested aggregate wealth minus the risk premium on that wealth. This risk premium compensates investors for bearing market risk and the risk of unfavorable changes in the economy resulting from climate change. This paper functions as an update of Discussion Paper 126 .

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    Paper provided by CPB Netherlands Bureau for Economic Policy Analysis in its series CPB Discussion Paper with number 257.

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    Date of creation: Sep 2013
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    Handle: RePEc:cpb:discus:257

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    1. Heal, Geoffrey, 2005. "Intertemporal Welfare Economics and the Environment," Handbook of Environmental Economics, in: K. G. Mäler & J. R. Vincent (ed.), Handbook of Environmental Economics, edition 1, volume 3, chapter 21, pages 1105-1145 Elsevier.
    2. Ravi Bansal & Marcelo Ochoa, 2011. "Temperature, Aggregate Risk, and Expected Returns," NBER Working Papers 17575, National Bureau of Economic Research, Inc.
    3. Robert J. Barro, 2009. "Rare Disasters, Asset Prices, and Welfare Costs," American Economic Review, American Economic Association, vol. 99(1), pages 243-64, March.
    4. Martin L. Weitzman, 2012. "Rare Disasters, Tail-Hedged Investments, and Risk-Adjusted Discount Rates," NBER Working Papers 18496, National Bureau of Economic Research, Inc.
    5. Mario Menegatti, 2009. "Optimal saving in the presence of two risks," Journal of Economics, Springer, vol. 96(3), pages 277-288, April.
    6. Geoffrey Heal, 2009. "Climate Economics: A Meta-Review and Some Suggestions for Future Research," Review of Environmental Economics and Policy, Association of Environmental and Resource Economists, vol. 3(1), pages 4-21, Winter.
    7. Detemple, Jerome B, 1986. " Asset Pricing in a Production Economy with Incomplete Information," Journal of Finance, American Finance Association, vol. 41(2), pages 383-91, June.
    8. Richard S. J. Tol, 2009. "The Economic Effects of Climate Change," Journal of Economic Perspectives, American Economic Association, vol. 23(2), pages 29-51, Spring.
    9. Merton, Robert C., 1977. "On the pricing of contingent claims and the Modigliani-Miller theorem," Journal of Financial Economics, Elsevier, vol. 5(2), pages 241-249, November.
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