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Title: Discounting the Future: on Climate Change, Ambiguity Aversion and Epstein-Zin Preferences

Author(s): Stan Olijslager and Sweder van Wijnbergen

Publication Date: May 2019

Keyword(s): ambiguity aversion, climate change, Epstein-Zin Preferences, Social cost of carbon and Stochastic Differential Utility

Programme Area(s): Financial Economics

Abstract: We show that empirically strongly supported deviations from standard expected time separable utility have a major impact on estimates of the willingness to pay to avoid future climate change risk. We propose a relatively standard integrated climate/economy model but add stochastic climate disasters. The model yields closed form solutions up to solving an integral, and therefore does not suffer from the curse of dimensionality of most numerical climate/economy models. Introducing Epstein-Zin preferences with an elasticity of substitution higher than one and ambiguity aversion leads to much larger estimates of the social cost of carbon (SCC) than obtained under power utility. The dominant parameters are the risk aversion coefficient and the elasticity of intertemporal substitution. Ambiguity aversion has more complicated consequences but overall also leads to substantially higher estimates of the SCC.

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Bibliographic Reference

Olijslager, S and van Wijnbergen, S. 2019. 'Discounting the Future: on Climate Change, Ambiguity Aversion and Epstein-Zin Preferences'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=13708