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Ambiguity and climate policy

  • Antony Millner
  • Simon Dietz
  • Geoffrey Heal

Economic evaluation of climate policy traditionally treats uncertainty by appealing to expected utility theory. Yet our knowledge of the impacts of climate policy may not be of sufficient quality to justify probabilistic beliefs. In such circumstances, it has been argued that the axioms of expected utility theory may not be the correct standard of rationality. By contrast, several axiomatic frameworks have recently been proposed that account for ambiguous beliefs. In this paper, we apply static and dynamic versions of a smooth ambiguity model to climate mitigation policy. We obtain a general result on the comparative statics of optimal abatement and ambiguity aversion and illustrate this sufficient condition in some simple examples. We then extend our analysis to a more realistic, dynamic setting, and adapt a well-known empirical model of the climate-economy system to show that the value of emissions abatement increases as ambiguity aversion increases, and that this �ambiguity premium� can in some plausible cases be very large.

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Paper provided by Grantham Research Institute on Climate Change and the Environment in its series GRI Working Papers with number 24.

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Date of creation: Aug 2010
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Handle: RePEc:lsg:lsgwps:wp24
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  4. Gilbert W. Bassett, 2004. "Pessimistic Portfolio Allocation and Choquet Expected Utility," Journal of Financial Econometrics, Society for Financial Econometrics, vol. 2(4), pages 477-492.
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