EAERE 2009 Amsterdam Jun 26, 2009 Discounting Investments in Mitigation and Adaptation (including...

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AmsterdamJun 26, 2009

Discounting Investments in Mitigation and Adaptation

(including dikes)

Rob Aalbers (CPB)

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Example

Question: in which of these cases is risk in terms of wealth higher?

Zeeland: in 1953 Zeeland: after 1986

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Example

p W

49% 100

49% 90

2% 02%

98%

Distribution of wealth at current dike level

Distribution of wealth after dike increase

p W

50% 100

50% 90

Another way to look at it:

After the increase of the dike it is as if the dike returns your wealth after a flood! This is called a hedge.Value of house: 90 or 100

with probability 1/2

Variance much lower!

More elaborate: systematic risk is much lower!

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Intuition

Example suggests that increases in the height of a dike:► Reduces expected loss of flooding► Decreases riskiness of aggregate wealth, i.e. the

dike is “a kind of a hedge”

In CBA the latter is normally not taken into account as the discount rates are exogenous.

Idea: Construct model where discount rates are endogenously determined by modelling both economic and climate/water risk explicitly.

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Essential features of the model

Utility:

Household may invest wealth, W, in n different sectors and 1 contingent claim, F.

Temperature evolves according to:

[ ( ), ( )]t

oJ E e U C t T t dt

( 1) ( 1) ( )dW a r W b r W rW C dt W a G bh d t

( , ) ( ) ( , ) ( )dT T t P t dt s T t d t

( ) ( , ) ( ) ( , ) ( ) ( )i i i i idK t T t K t dt g T t K t d t

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Uncertainty

1 11 1,( ) ( ), , ( ), ( ), ( )e n e n c ncd t d t d t d t d t

Economic shocks:

- productivity

- demand

- technology

Climate shocks:

- release of methane

- water vapour

- solar intensity

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Example

15

16

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20

21

22

23

0 20 40 60 80 100

T1

T2

T3

Drift

years

degrees ºC

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Result

Difference in discount rates between two sectors i and j is equal to:

Discount rate in sectors are equal if

The vector, gi, signifies the contribution of the different shocks to the rate of return in any specific sector

( ) ( )ˆWW WTi j

W Wi j i jg

J JG ag W s

J Jg g

i jg g

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Sectoral setup of the model

Sector 1: Non-climate Sector 2: Adaptation Sector 3: Mitigation

Remark: all sectors produce the same consumption good with a different embedded technology

Question: What does adaptation and mitigation mean in terms of the model parameters?

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Embedded technologies

Sector i

Technology for producing C(t) including adaptation technology if appropriate

Technology for producing energy

i (and )i ig

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Description of ‘stylized’ sectors

**2 1 2; : ( , ) ( , )c cT Tg T t g T t

*1 1; : ( , ) 0cT Tg T t

3 30; ( , ) unrestrictedcg T t

Non-climate

Adaptation

Mitigation

Expected changes in T decrease rate of return, unexpected changes as well

For high T: changes in T have less effect on adaptation compared to non-climate; only climate shocks!

Shocks have same impact on rate of return of consumption technology (nothing changed compared to non-climate).

Differential impact on energy technology possible. This is technology characteristic, not mitigation characteristic.

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Expected rate of return

T

( )i T

1( )T

2 ( )T

3( )T

Relevant range

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Almost done!

Assumption:► Shifts in the state variabele T are unfavorable, i.e. ► An unexpected rise in temperature lowers the rate of return in

the economy:

Recall:

Conclusion: 1. Climate risk reduces discount rates adaptation.

2. Climate risk may reduce, incease or have no effect on discount rates mitigation

3. (2) is due to the characteristics of energy technology used not because of characteristics of mitigation!

0WTJ

ˆ( ) ( )WW WTi j i j i j

W W

J Jg g G aW g g s

J J

( , ) 0i ica g T t

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So, what is going on here?

Adaptation is dynamic hedge, i.e protects value against unexpected changes in state variable T (cf. Merton 1992)

Discount rate mitigation “equal” to non-climate. So, no hedge?

Let’s go back to basics:► Adaptation = “adjusting to different conditions”

you try to become less vulnerable w.r.t. temperature; you do not change process of temperature.

► Mitigation = “making something less severe or less unpleasant” you change temperature process, but remain vulnerable to any remaining shocks (which you expect to be less severe).

► Subtle difference!

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So, is Nordhaus right?

Discount rate mitigation:► Is equal to discount rate non-climate► Equal to sum of risk free rate and risk premium

6%?

Well, we haven’t looked at the risk free rate, yet!

var cov( , )ˆ ( ) WW WT CT

W W W C

J J EdUJ W W Tr a

J J W J W U dt

Expected rate of return

Risk premium on wealth

Certainty equivalent rate of return on savings

Benefits of delaying consumption

=

Rate of time preference

Expected rate of change in marginal utility

Cost of expected consumption renunciation

- Wealth effect

- Precautionary effect

- “Perception effect”

THE RAMSEY RULE IN A STOCHASTIC WORLD

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Discounting mitigation

Consumer may balance costs and benefits of delaying consumption by:► Saving more (traditional method)► Shifting investment from non-climate to mitigation

sector:– Lower exp. private return on investment – Lower emissions:

– Lead to lower expected damages– May change the risk premium of aggregate

wealth– May change the perception of marginal utility

Hypothesis:► Term structure of risk free rate is decreasing in

equilibrium?► Remember: all discount rates are path dependent!

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Back to the debate on discounting mitigation

Nordhaus: discount everything at 6% Stern: discount everything at 1.7% Weitzman:

► (JEEM,1998): term structure risk free rate is decreasing

► (JEL, 2007): lower risk premium for mitigation

This paper tells you that the signal/incentive for investing in:► Adaptation comes from lower risk premium► Mitigation does NOT come from lower risk premium.

It might come from decreasing term structure.

To be confirmed…

EAERE 2009 Amsterdam Jun 26, 2009 Discounting Investments in Mitigation and Adaptation (including...

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