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Fat Tails, Thin Tails, and Climate Change Policy

  • Robert S. Pindyck

Climate policy is complicated by the considerable compounded uncertainties over the costs and benefits of abatement. We don't even know the probability distributions for future temperatures and impacts, making cost-benefit analysis based on expected values challenging to say the least. There are good reasons to think that those probability distributions are fat-tailed, which implies that if social welfare is based on the expectation of a CRRA utility function, we should be willing to sacrifice close to 100% of GDP to reduce GHG emissions. I argue that unbounded marginal utility makes little sense, and once we put a bound on marginal utility, this implication of fat tails goes away: Expected marginal utility will be finite even if the distribution for outcomes is fat-tailed. Furthermore, depending on the bound on marginal utility, the index of risk aversion, and the damage function, a thin-tailed distribution can yield a higher expected marginal utility (and thus a greater willingness to pay for abatement) than a fat-tailed one.

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File URL: http://www.nber.org/papers/w16353.pdf
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 16353.

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Date of creation: Sep 2010
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Publication status: published as Robert S. Pindyck, 2011. "Fat Tails, Thin Tails, and Climate Change Policy," Review of Environmental Economics and Policy, Oxford University Press for Association of Environmental and Resource Economists, vol. 5(2), pages 258-274, Summer.
Handle: RePEc:nbr:nberwo:16353
Note: EEE IO PE
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  1. Robert S. Pindyck & Neng Wang, 2009. "The Economic and Policy Consequences of Catastrophes," NBER Working Papers 15373, National Bureau of Economic Research, Inc.
  2. Pindyck, Robert S., 2012. "Uncertain outcomes and climate change policy," Journal of Environmental Economics and Management, Elsevier, vol. 63(3), pages 289-303.
  3. Geoffrey Heal & Bengt Kriström, 2002. "Uncertainty and Climate Change," Environmental & Resource Economics, European Association of Environmental and Resource Economists, vol. 22(1), pages 3-39, June.
  4. Adam Daigneault & Steve Newbold, 2009. "Climate Response Uncertainty and the Unexpected Benefits of Greenhouse Gas Emissions Reductions," NCEE Working Paper Series 200806, National Center for Environmental Economics, U.S. Environmental Protection Agency, revised Mar 2009.
  5. Robert S. Pindyck, 2010. "Modeling the Impact of Warming in Climate Change Economics," Working Papers 1001, Massachusetts Institute of Technology, Center for Energy and Environmental Policy Research.
  6. Pindyck, Robert S., 2002. "Optimal timing problems in environmental economics," Journal of Economic Dynamics and Control, Elsevier, vol. 26(9-10), pages 1677-1697, August.
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