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Tail-Hedge Discounting and the Social Cost of Carbon

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  • Martin L. Weitzman

Abstract

The choice of an overall discount rate for climate change investments depends critically on how different components of investment payoffs are discounted at differing rates reflecting their underlying risk characteristics. Such underlying rates can vary enormously, from ?1 percent for idiosyncratic diversifiable risk to ?7 percent for systematic nondiversifiable risk. Which risk-adjusted rate is chosen can have a huge impact on cost-benefit analysis. In this expository paper, I attempt to set forth in accessible language with a simple linear model what I think are some of the basic issues involved in discounting climate risks. The paper introduces a new concept that may be relevant for climate-change discounting: the degree to which an investment hedges against the bad tail of catastrophic damages by insuring positive expected payoffs even under the worst circumstances. The prototype application is calculating the social cost of carbon.

Suggested Citation

  • Martin L. Weitzman, 2013. "Tail-Hedge Discounting and the Social Cost of Carbon," Journal of Economic Literature, American Economic Association, vol. 51(3), pages 873-882, September.
  • Handle: RePEc:aea:jeclit:v:51:y:2013:i:3:p:873-82
    Note: DOI: 10.1257/jel.51.3.873
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    1. Maria Sandsmark & Haakon Vennemo, 2007. "A portfolio approach to climate investments: CAPM and endogenous risk," Environmental & Resource Economics, Springer;European Association of Environmental and Resource Economists, vol. 37(4), pages 681-695, August.
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    3. Robert S. Pindyck, 2013. "Climate Change Policy: What Do the Models Tell Us?," Journal of Economic Literature, American Economic Association, vol. 51(3), pages 860-872, September.
    4. Laurie Johnson & Chris Hope, 2012. "The social cost of carbon in U.S. regulatory impact analyses: an introduction and critique," Journal of Environmental Studies and Sciences, Springer;Association of Environmental Studies and Sciences, vol. 2(3), pages 205-221, September.
    5. Campbell, John Y., 2003. "Consumption-based asset pricing," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, edition 1, volume 1, chapter 13, pages 803-887, Elsevier.
    6. Nicholas Stern, 2013. "The Structure of Economic Modeling of the Potential Impacts of Climate Change: Grafting Gross Underestimation of Risk onto Already Narrow Science Models," Journal of Economic Literature, American Economic Association, vol. 51(3), pages 838-859, September.
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    More about this item

    JEL classification:

    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
    • Q54 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Environmental Economics - - - Climate; Natural Disasters and their Management; Global Warming
    • Q58 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Environmental Economics - - - Environmental Economics: Government Policy

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