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Optimal Discount Rates for Investments in Mitigation and Adaptation

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  • Rob Aalbers

    () (CPB Netherlands Bureau for Economic Policy Analysis)

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 .

Suggested Citation

  • Rob Aalbers, 2013. "Optimal Discount Rates for Investments in Mitigation and Adaptation," CPB Discussion Paper 257, CPB Netherlands Bureau for Economic Policy Analysis.
    • Handle: RePEc:cpb:discus:257
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    References listed on IDEAS

    as
    1. Christian Gollier, 2012. "Evaluation of Long-Dated Investments under Uncertain Growth Trend, Volatility and Catastrophes," CESifo Working Paper Series 4052, CESifo Group Munich.
    2. 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.
    3. Mario Menegatti, 2009. "Optimal saving in the presence of two risks," Journal of Economics, Springer, vol. 96(3), pages 277-288, April.
    4. 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.
    5. Gollier, Christian, 2016. "Evaluation of long-dated assets: The role of parameter uncertainty," Journal of Monetary Economics, Elsevier, vol. 84(C), pages 66-83.
    6. 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.
    7. Ravi Bansal & Marcelo Ochoa, 2011. "Temperature, Aggregate Risk, and Expected Returns," NBER Working Papers 17575, National Bureau of Economic Research, Inc.
    8. 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.
    9. Aase, Knut K., 2011. "The long term equilibrium interest rate and risk premiums under uncertainty," Discussion Papers 2011/4, Norwegian School of Economics, Department of Business and Management Science.
    10. 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.
    11. Robert J. Barro, 2009. "Rare Disasters, Asset Prices, and Welfare Costs," American Economic Review, American Economic Association, vol. 99(1), pages 243-264, March.
    12. Martin L. Weitzman, 2012. "Rare Disasters, Tail-Hedged Investments, and Risk-Adjusted Discount Rates," NBER Working Papers 18496, National Bureau of Economic Research, Inc.
    13. Detemple, Jerome B, 1986. " Asset Pricing in a Production Economy with Incomplete Information," Journal of Finance, American Finance Association, vol. 41(2), pages 383-391, June.
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    More about this item

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • H43 - Public Economics - - Publicly Provided Goods - - - Project Evaluation; Social Discount Rate
    • Q51 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Environmental Economics - - - Valuation of Environmental Effects
    • Q54 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Environmental Economics - - - Climate; Natural Disasters and their Management; Global Warming

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