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Epstein–Zin Utility in DICE: Is Risk Aversion Irrelevant to Climate Policy?

  • Frank Ackerman

    ()

  • Elizabeth Stanton

    ()

  • Ramón Bueno

    ()

Climate change involves uncertain probabilities of catastrophic risks, and very longterm consequences of current actions. Climate economics, therefore, is centrally concerned with the treatment of risk and time. Yet conventional assumptions about utility and optimal economic growth create a perverse connection between risk aversion and time preference, such that more aversion to current risks implies less concern for future outcomes, and vice versa. The same conflation of risk aversion and time preference leads to the equity premium puzzle in finance. A promising response to the equity premium puzzle, the recursive utility of Epstein and Zin, allows separation of risk aversion and time preference—at the cost of considerable analytic complexity. We introduce an accessible implementation of Epstein–Zin utility into the DICE model of climate economics, creating a hybrid “EZ-DICE” model. Using Epstein–Zin parameters from the finance literature and climate uncertainty parameters from the science literature, we find that the optimal climate policy in EZ-DICE calls for rapid abatement of carbon emissions; it is similar to standard DICE results with the discount rate set to equal the risk-free rate of return. EZ-DICE solutions are sensitive to the intertemporal elasticity of substitution, but remarkably insensitive to risk aversion. Insensitivity to risk aversion may reflect the difficulty of modeling catastrophic risks within DICE. Implicit in DICE are strong assumptions about the cost of climate stabilization and the certainty and speed of success; under these assumptions, risk aversion would in fact be unimportant. A more realistic analysis will require a subtler treatment of catastrophic climate risk. Copyright Springer Science+Business Media Dordrecht 2013

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Article provided by European Association of Environmental and Resource Economists in its journal Environmental and Resource Economics.

Volume (Year): 56 (2013)
Issue (Month): 1 (September)
Pages: 73-84

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Handle: RePEc:kap:enreec:v:56:y:2013:i:1:p:73-84
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  1. Matthew Rabin., 2000. "Risk Aversion and Expected-Utility Theory: A Calibration Theorem," Economics Working Papers E00-279, University of California at Berkeley.
  2. Epstein, Larry G & Zin, Stanley E, 1991. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: An Empirical Analysis," Journal of Political Economy, University of Chicago Press, vol. 99(2), pages 263-86, April.
  3. Buchholz, Wolfgang & Schymura, Michael, 2010. "Expected Utility theory and the tyranny of catastrophic risks," ZEW Discussion Papers 10-059, ZEW - Zentrum für Europäische Wirtschaftsforschung / Center for European Economic Research.
  4. Weitzman, Martin L., 2009. "On Modeling and Interpreting the Economics of Catastrophic Climate Change," Scholarly Articles 3693423, Harvard University Department of Economics.
  5. Helgeson, Jennifer & Dietz, Simon & Atkinson, Giles D. & Hepburn, Cameron & Sælen, Håkon, 2009. "Siblings, not triplets: social preferences for risk, inequality and time in discounting climate change," Economics - The Open-Access, Open-Assessment E-Journal, Kiel Institute for the World Economy, vol. 3, pages 1-28.
  6. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
  7. Minh Ha-Duong & Nicolas Treich, 2004. "Risk aversion, intergenerational equity and climate change," Working Papers 25611, Institut National de la Recherche Agronomique, France.
  8. Richard B. Howarth, 2003. "Discounting and Uncertainty in Climate Change Policy Analysis," Land Economics, University of Wisconsin Press, vol. 79(3), pages 369-381.
  9. Noah Kaufman, 2012. "The bias of integrated assessment models that ignore climate catastrophes," Climatic Change, Springer, vol. 110(3), pages 575-595, February.
  10. Ackerman, Frank & Stanton, Elizabeth A., 2011. "Climate risks and carbon prices: Revising the social cost of carbon," Economics Discussion Papers 2011-40, Kiel Institute for the World Economy.
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  12. Epstein, Larry G & Zin, Stanley E, 1989. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: A Theoretical Framework," Econometrica, Econometric Society, vol. 57(4), pages 937-69, July.
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