DP13708 Discounting the Future: on Climate Change, Ambiguity Aversion and Epstein-Zin Preferences

Author(s): Stan Olijslager, Sweder van Wijnbergen
Publication Date: May 2019
Date Revised: January 2021
Keyword(s): ambiguity aversion, climate change, Epstein-Zin Preferences, Social cost of carbon, Stochastic Differential Utility
JEL(s): G12, G13, Q51, Q54
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=13708

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.