Climate Policy Under Fat-Tailed Risk: An Application of Dice
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Climate Policy Under Fat-Tailed Risk: An Application of Dice In Chang Hwang · Frédéric Reynès · Richard S. J. Tol
Accepted: 8 April 2013 © Springer Science+Business Media Dordrecht 2013
Abstract Uncertainty plays a significant role in evaluating climate policy, and fat-tailed uncertainty may dominate policy advice. Should we make our utmost effort to prevent the arbitrarily large impacts of climate change under deep uncertainty? In order to answer to this question, we propose a new way of investigating the impact of (fat-tailed) uncertainty on optimal climate policy: the curvature of the optimal carbon tax against the uncertainty. We find that the optimal carbon tax increases as the uncertainty about climate sensitivity increases, but it does not accelerate as implied by Weitzman’s Dismal Theorem. We find the same result in a wide variety of sensitivity analyses. These results emphasize the importance of balancing the costs of climate change against its benefits, also under deep uncertainty. Keywords Climate change · Decision making under uncertainty · Fat-tailed risk · Integrated assessment JEL Classification
Q54
I. C. Hwang (B) · F. Reynès · R. S. J. Tol Institute for Environmental Studies, Vrije Universiteit, Amsterdam, The Netherlands e-mail: [email protected] R. S. J. Tol Department of Economics, University of Sussex, Brighton, UK R. S. J. Tol Department of Spatial Economics, Vrije Universiteit, Amsterdam, The Netherlands F. Reynès OFCE Sciences Po’s Economic Research Centre, Paris, France F. Reynès TNO—Netherlands Organisation for Applied Scientific Research, Delft, The Netherlands
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1 Introduction Everything about climate change is uncertain. Although this has been acknowledged for a long time, a recent paper by Weitzman (2009a) emphasized the importance of conceptualizing climate policy as risk management. Weitzman (2009a) formalizes an earlier suspicion by Tol (2003): there is good reason to believe that the uncertainty about the impacts of climate change is fat-tailed.1 That is, the variance or even the mean of the distribution of the objective value (welfare) may not exist. This violates the axioms of decision making under uncertainty, leading to an arbitrarily large willingness to pay for the reduction of carbon dioxide emissions (Weitzman’s Dismal Theorem). Weitzman (2009a) and Tol (2003) diagnose the problem but do not offer a solution. Moreover, Weitzman’s characterization of climate policy is incomplete because it considers the impacts of climate change but ignores the impacts of greenhouse gases (GHG) emissions reduction. As shown by Hennlock (2009), this materially affects the results. Intuitively, the reasoning is something as follows. Weitzman (2009a) argues that the certainty-equivalent of the marginal damage cost of carbon dioxide emissions and thus the willingness to pay for emission reduction are arbitrarily large (or infinite). Taken at face value, this implies that an arbitrarily large carbon tax should be imposed—or that emissions should be driven to zero immedi
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