Chapter 12 - Epstein–Zin Utility in DICE: Is Risk Aversion Irrelevant to Climate Policy?

Summary

Climate change involves uncertain probabilities of catastrophic risks, and very long-term consequences of current actions. Climate economics, therefore, is centrally concerned with the treatment of risk and time. Yet conventional assumptions about utility and optimal economic growth create a perverse connection between risk aversion and time preference, such that more aversion to current risks implies less concern for future outcomes, and vice versa. The same conflation of risk aversion and time preference leads to the equity premium puzzle in finance. A promising response to the equity premium puzzle, the recursive utility of Epstein and Zin, allows separation of risk aversion and time preference – at the cost of considerable analytic complexity. We introduce an accessible implementation of Epstein–Zin utility into the DICE model of climate economics, creating a hybrid “EZ–DICE” model. Using Epstein–Zin parameters from finance literature and climate uncertainty parameters from science literature, we find that the optimal climate policy in EZ–DICE calls for rapid abatement of carbon emissions; it is similar to standard DICE results with the discount rate set to equal the risk-free rate of return. EZ–DICE solutions are sensitive to the intertemporal elasticity of substitution, but remarkably insensitive to risk aversion. Insensitivity to risk aversion may reflect the difficulty of modeling catastrophic risks within DICE. Implicit in DICE are strong assumptions about the cost of climate stabilization and the certainty and speed of success; under these assumptions, risk aversion would in fact be unimportant. A more realistic analysis will require a subtler treatment of catastrophic climate risk.

Introduction: The Need for a New Utility Function

Economic analysis of climate change is often framed in cost–benefit terms. On the one hand, spending money now on reducing emissions means that less is available for current consumption and ordinary investment. On the other hand, not spending money now on reducing emissions means that less will be available for future consumption and investment as climate damages increase. An optimal economic growth path can be calculated, subject to these two constraints; among other results, it includes an optimal climate policy, or pace of emission reduction.