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Risk and Return in Environmental Economics

  • Robert S. Pindyck

I examine the risk/return tradeoff for environmental investments, and its implications for policy choice. Consider a policy to reduce carbon emissions. To what extent does the value of such a policy depend on the expected future damages from global warming versus uncertainty over those damages, i.e., on the expected benefits from the policy versus their riskiness? And to what extent should the policy objective be a reduction in the expected temperature increase versus a reduction in risk? Using a simple model of a stock externality (e.g., temperature) that evolves stochastically, I examine the ``willingness to pay" (WTP) for alternative policies that would reduce the expected damages under ``business as usual" (BAU) versus the variance of those damages. I also show how one can compute ``iso-WTP" curves (social indifference curves) for combinations of risk and expected returns as policy objectives. Given cost estimates for reducing risk and increasing expected returns, one can compute the optimal risk-return mix for a policy, and the policy's social surplus. I illustrate these results by calibrating the model to data for global warming.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 18262.

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Date of creation: Jul 2012
Date of revision:
Publication status: published as “Risk and Return in the Design of Environmental Policy,” Journal of the Association of Environmental and Resource Economists, September 2014.
Handle: RePEc:nbr:nberwo:18262
Note: EEE
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  1. Brock,W.A. & Taylor,M.S., 2004. "The Green Solow model," Working papers 16, Wisconsin Madison - Social Systems.
  2. Partha Dasgupta, 2008. "Discounting climate change," Journal of Risk and Uncertainty, Springer, vol. 37(2), pages 141-169, December.
  3. Robert S. Pindyck, 2009. "Uncertain Outcomes and Climate Change Policy," NBER Working Papers 15259, National Bureau of Economic Research, Inc.
  4. Ravi Bansal & Marcelo Ochoa, 2011. "Temperature, Aggregate Risk, and Expected Returns," NBER Working Papers 17575, National Bureau of Economic Research, Inc.
  5. Ravi Bansal & Marcelo Ochoa, 2011. "Welfare Costs of Long-Run Temperature Shifts," NBER Working Papers 17574, National Bureau of Economic Research, Inc.
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