EAERE 2009 Amsterdam Jun 26, 2009 Discounting Investments in Mitigation and Adaptation (including dikes) Rob Aalbers (CPB)

EAERE 2009 Amsterdam Jun 26, 2009 Example Question: in which of these cases is risk in terms of wealth higher? Zeeland: in 1953Zeeland: after 1986

EAERE 2009 Amsterdam Jun 26, 2009 Example pW 49%100 49%90 2%0 98% Distribution of wealth at current dike level Distribution of wealth after dike increase pW 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!

EAERE 2009 Amsterdam Jun 26, 2009 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.

EAERE 2009 Amsterdam Jun 26, 2009 Essential features of the model Utility: Household may invest wealth, W, in n different sectors and 1 contingent claim, F. Temperature evolves according to:

EAERE 2009 Amsterdam Jun 26, 2009 Uncertainty Economic shocks: - productivity - demand - technology Climate shocks: - release of methane - water vapour - solar intensity

EAERE 2009 Amsterdam Jun 26, 2009 Example years degrees ºC

EAERE 2009 Amsterdam Jun 26, 2009 Result Difference in discount rates between two sectors i and j is equal to: Discount rate in sectors are equal if The vector, g i, signifies the contribution of the different shocks to the rate of return in any specific sector

EAERE 2009 Amsterdam Jun 26, 2009 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?

EAERE 2009 Amsterdam Jun 26, 2009 Embedded technologies Sector i Technology for producing C(t) including adaptation technology if appropriate Technology for producing energy

EAERE 2009 Amsterdam Jun 26, 2009 Description of ‘stylized’ sectors 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.

EAERE 2009 Amsterdam Jun 26, 2009 Expected rate of return T Relevant range

EAERE 2009 Amsterdam Jun 26, 2009 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!

EAERE 2009 Amsterdam Jun 26, 2009 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!

EAERE 2009 Amsterdam Jun 26, 2009 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!

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

EAERE 2009 Amsterdam Jun 26, 2009 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!

EAERE 2009 Amsterdam Jun 26, 2009 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…