Intergenerational equity, risk and climate modeling

1. Intergenerational equity, risk and climate modeling Paper presented by John Quiggin* Thirteenth Annual Conference on Global Economic Analysis Penang, Malaysia, 9-11 June 2010 * Australian Research Council Federation Fellow * Risk and Sustainable Management Group, Schools of Economics and Political Science,University of Queensland

2. Web Sites RSMG http://www.uq.edu.au/economics/rsmg/index.htm Quiggin http://www.uq.edu.au/economics/johnquiggin WebLog http://johnquiggin.com

3. Modelling climate change • Policy decisions now, outcomes over next century • Stabilization, Business as Usual, Wait and See • Time and uncertainty

4. Stabilization: modest uncertainty • Estimated cost 0-4 per cent of 2050 NWI • Lower bound of 0 (some regrets) • Upper bound ‘all renewables’, 10 per cent • Back of the envelope calculation • 50 per cent reduction in global emissions • Income share of energy*elasticity*tax-rate^2 • 0.04*1*1=0.04

5. Costs of doing nothing • Should be evaluated relative to stabilisation • Stern vs Nordhaus & Boyer • Differences relate mostly to discounting • Neither deals well with uncertainty

6. Time, risk, equity • Closely related problems • Outcomes differentiated by dates, states of nature, persons • All conflated in standard discussions of discounting

7. The expected utility model • Appealing • Normatively plausible axioms • Tractable • Models of asset pricing, discounting • Empirically unsatisfactory • Allais, Ellsberg 'paradoxes' • Equity premium puzzle

8. Implications • Assuming rising incomes, a dollar of extra income is worth less in the future than it is today • Under uncertainty, a dollar of extra income in a bad state of nature is worth more than a dollar in a good state of nature • Transferring income from rich to poor people improves aggregate welfare • Same function captures all three!

9. Discounting under EU • r = δ + η*g • r is the rate of discount • η is the elasticity of substitution for consumption, • g is the rate of growth of consumption per person • δ is the inherent discount rate.

10. Stern's parameter values • δ = 0.001 (no inherent discounting) • η = 1 (log utility) • g varies but generally around 0.02 • Implies r=0.021 (2.1 per cent)

11. Log utility • Given percentage change in income equally valuable at all income levels • Ideal for simple analysis over long periods with uncertain growth rates

12. Extinction • Covers any event that renders all calculations irrelevant • Stern uses 0.001, arguably should be higher

13. Inherent discounting • Widely used • No obvious justification in social choice • Overlapping generations problem • Small probability of extinction

14. Overlapping generations problem • ‘Future generations’ are alive today • Not ‘current vs future generations’ but ‘older vs younger cohorts’

15. Inherent discounting violates standard norms • Equal treatment of contemporaries • Equal value on lifetime utility • Overlapping generations create an unbroken chain • Implies no inherent discounting

16. Overlapping generations model • All generations live two periods • Additively separable utilitarian preferences • Can include inherent discounting of own consumption • V = u(c1)+βu(c2) • Social choices over utility profiles for Tgenerations

17. No discounting proposition • Assumptions • Pareto optimality • Independence • Utilitarianism for contemporaries • Conclusion: Maximize sum over generations of lifetime utility ΣtV

18. Sketch proof • Any transfer within generations that increases lifetime utility V increases social welfare (Pareto optimality) • Any transfer between currently living generations that increases aggregate V increases social welfare (Utilitarianism within periods) • General result follows from Independence (+ Transitivity)

20. Key implication • Preferences including inherent discounting justify transfers from consumption in old age to consumption in youth within a generation • Don’t justify transfers from later-born to earlier-born cohorts

21. Market comparisons • Stern's choice fit well with some observations (market rates of interest) • Badly with others (average returns to capital)

22. Equity premium puzzle • Rate of return to equity much higher than for bonds • Can't be explained by EU under • Plausible risk aversion • Perfect capital markets • Intertemporally separable utility • Key assumptions of EU discounting theory

23. Reasons for favoring low r • Bond rate is most plausible market rate • Price of environmental services likely to rise in bad states • Standard procedures don't take adequate account of tails of distribution

24. Implications for modelling • Need for explicit modelling of uncertainty and learning • Need to model right-hand tail of damage distribution • Representation of time and state of nature in discounting • EU vs non-EU

25. Explicit modelling of uncertainty • At least three possible damage states • Median, High, Catastrophic • Learning over time • A complex control problem • Monte Carlo?

26. Right-hand tail • Equilibrium warming above 6 degrees (Weitzman iconic value) • Poorly represented in current models • Account for large proportion of expected loss

27. State-contingent discounting • Bad states, low discount rates • Negative growth path, negative discount rates • Over long periods, these may dominate welfare calculations (Newell and Pizer)

28. EU vs non-EU • Non-EU treatment of time and risk • Hyperbolic discounting (Nordhaus & Boyer) • Rank-dependent probability (Prospect theory) • Non-EU models allow more flexibility, but more problematic for welfare analysis • Dynamic inconsistency • Maybe not a big problem in this case

29. Concluding comments • Uncertainty still problematic • Catastrophic risk poorly understood • Presumption in favour of early action