Tail-Hedge Discounting and the Social Cost of Carbon

By Martin Weitzman. 2013

115 citations recorded by the source corpus.

The choice of an overall discount rate for climate change investments depends critically on how different components of investment payoffs are discounted at differing rates reflecting their underlying risk characteristics. Such underlying rates can vary enormously, from ?1 percent for idiosyncratic diversifiable risk to ?7 percent for systematic nondiversifiable risk. Which risk-adjusted rate is chosen can have a huge impact on cost-benefit analysis. In this expository paper, I attempt to set forth in accessible language with a simple linear model what I think are some of the basic issues involved in discounting climate risks. The paper introduces a new concept that may be relevant for climate-change discounting: the degree to which an investment hedges against the bad tail of catastrophic damages by insuring positive expected payoffs even under the worst circumstances. The prototype application is calculating the social cost of carbon.

Subfields: Economics and Econometrics, Management, Monitoring, Policy and Law, Renewable Energy, Sustainability and the Environment

View Paper: https://www.semanticscholar.org/paper/ca23675ec66cc731a261b9fa26ee4b77f3eca752

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Citations in the corpus

Path dependence, innovation and the economics of climate change (2014, background): “Indeed, standard integrated assessment models suffer from a variety of problems, such as extreme sensitivity to arbitrary parameters and the inability to properly incorporate the possibility of catastrophic outcomes (Pindyck, 2013; Stern, 2013; Weitzman, 2013; Dietz and Stern, 2014).”
What Do We Learn from the Weather? The New Climate-Economy Literature (2014, unknown): “Even amongst those who agree that the social welfare function should be calibrated using empirical evidence, there is considerable controversy over which market discount rate to use (Litterman 2013; Weitzman 2013) Nonetheless, choices around social welfare functions can in principle be treated trans”
Faraway, So Close: Coupled Climate and Economic Dynamics in an Agent-based Integrated Assessment Model (2018, unknown): “However, IAMs have been fiercely criticized by an increasing number of scholars for their simplifying assumptions (see Pindyck, 2013; Stern, 2013, 2016; Weitzman, 2013; Revesz et al., 2014; Farmer et al., 2015; Balint et al., 2017, among many contributions).”
The Structure of Economic Modeling of the Potential Impacts of Climate Change: Grafting Gross Underestimation of Risk onto Already Narrow Science Models (2013, background): “31 Kopp, Hsiang, and Oppenheimer (2013) provide a short summary of the IAMs, including their shortcomings, and a proposal for taking IAMs forward.”
Complexity and the Economics of Climate Change: A Survey and a Look Forward (2017, unknown): “There is growing concern in the literature that this picture might convey a false impression of control (see Pindyck, 2013; Stern, 2013, 2016; Weitzman, 2013; Revesz et al., 2014; Farmer et al., 2015, among many contributions) and that IAMs might underestimate both the cost of climate change and…”
The climate beta (2018, background): “Weitzman (2013) extended the idea that emissions abatement is a hedging strategy against macro-economic risk, invoking potential catastrophic climate change and its avoidance, while Daniel et al. (2015) also ﬁnd a negative climate β in the more general context of Epstein-Zin preferences, since…”