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The Economics of Climate Change
The basic mechanism
In the long run perspective
Do not mix up with Ozone layers
• Both are environmental problems
• Both are related to the atmosphere
• But they different issues
– The atomosphere is so complex that more than one
process may go on there
• The ozone layer stop ultra-violet rays
– With a thin ozone layer, skin cancer more likely
– But note: This is an example demonstrating that
international agreement can be successful!
• Global warming is an other problem
International agreement
• The problems of reaching an agreement on
CO2 is eminent.
• In addition to the incentives discussed, we
have distributional issues.
– The cost likely to be born by developing countries
– These countries have not caused the problems.
– Equal emission cut in % will harm the poor
– Equal emissions per capita will gain China and
India hugely.
The Kyoto protocol
• Agreement from December 1997
• Annex I: Countries listed to take cut in
emission
– Countries with emissions above 2 tC/cap 1990
• Reductions relative to 1990-level.
– Not by populations or GDP
– Avoid strategic emissions
• Annex I countries may induce reduction in
Non-Annex I countries through Clean
Development mechanisms (CDM)
Emissions 2000 relative to target
Emission trading in Kyoto
• Was controversial in negotiations
– Concern about market power from large sellers (Russia)
and buyers (US)
– Resistance to emission trading in general.
• Two main mechanism
– Clean Development Mechanism (CDM) Countries with
comittments can pay for development projects in countries
without committment provided these would not be
undertaken otherwise.
– Joint implementation: Two or more countries with
committment can jointly implement their committment
(Trade quotas; EU has redistributed their quota and
established a market)
Returning to optimal policy
Recall from last week
• Nordhaus find an optimal carbon price of
27$/tC
• Stern find an optimal carbon price at 250$/tC
• The main different is the discount rate
– The Stern review implicitly uses 1.4%
– Nordhaus uses 4% discount rate, but a 6% return
on capital.
Return to investments
• If we invest 1 million $ today, what will it be
worth 100 years from now:
– In Treasury Bills: at most 2,7 million $ (1%)
– In stocks: 2,2 billion $ (historical return, 8%)
• Why this huge difference?
– Uncertainty explains some of the difference
– But not all of it
– Returns to stock may be lower if we estimate it
today.
A Crash-course in Finance; CAPM
• An investor is better of owning 50% of two firms
than 100% of one.
– If one firm get bankrupt he is still not broke.
• The best hedged portfolio owns a share of all
stocks. (The market portfolio)
• Now consider selling 1000 $ of the portfolio and
buy stock A: Will the portfolio be more or less
risky?
– Depends on the correlation with the market portfolio.
Example: To assets
• Both A and B pays 1 million Kroner with
probability 0.1%, otherwise nothing?
– Are they equally risky?
• Depends on how they correlate with your
wealth:
– A pay 1 million if your house burns.
– B pay 1 million if the stock market is excep. good.
• A makes you wealth less uncertain, B makes it
more uncertain.
The Capital Asset Pricing Model
(CAPM)
r  rF   (rM  rF )
rF : The risk free rate
rM : Return on the market portfolio
r : Required return on the asset in question
cov( r , rM )

var( rM )
To fix ideas : rF  1%, rM  7%
Does climate abatement add to future
uncertainty?
• Nordhaus: D’(A) is positively correlated with
future GDP.
– There is more at stake when future GDP is high
– Implies a discount rate above the Treasury bill
(1%)
• Howarth estimate the CAPM model and finds
a discount rate much closer to 1% than to 8%.
Temperature change and consumption
Subjective probabilities and tails
• Difficult to estimate probabilities
– Not like a dice we can roll hundreds of times and
observe frequencies
• The rare events that we almost never observe,
may be the most important.
The equity premium puzzle
• If stock pay 7% more than bonds, why don’t
we put all our wealth into bonds?
– Risk aversion must be implausibly high to explain
it
– The returns to stock may be overestimated?
– Some other theories, resolution of uncertainty,
behavioral economics, etc.
• The implication for climate discounting not
well studied.
The tick tail (Weitzman)
• Consider the St. Petersburg paradox
– Flip a coin until tail in n’th flip
– Payment 2 to the n’th, 2,4,8,16,32…
– Expected value
1
1
1
1
2  4  8  16  ...  1  1  1  1...  
2
4
8
16
• If we run 100 000 simulation, we will most likely not
observe n above 30
– Estimated value will be rather small
• With 100 000 observation we will miss the tail
– And hence miss the real expected value
• In climate chance the extreme event are important,
events we do not observe and no model simulates
Assessing the tail of climate change
(Weitzman)
• There are hundreds of simulation of temperature change
provided we stabilize at 560 ppm (2x 280 ppm, the preindustrial level)
• 1% of these give temperature change > 10 degree
– The premise ignores feedback, methane will be released from
the tundra, likely temperature increase is up to 20 degrees; the
difference between summer and winter in Oslo.
– No guarantee that mankind will survive
– D’(A) and GDP negatively correlated
– Weitzman conclude that the optimal carbon price is almost
infinite.
• Note: It is highly unlikely that the world will be able to
stabilize CO2 at a level as low as 560 ppm