Pricing Uncertainty Induced by Climate Change

Do uncertainties increase the expected cost of carbon?

Michael Barnett, William Brock, and Lars Peter Hansen introduce a framework that combines decision theory and asset pricing tools to assess the economic impacts of climate change along with multiple components of uncertainty.

Their study "Pricing Uncertainty Induced by Climate Change" focuses on the social cost of carbon (SCC) to highlight that:

• Climate change uncertainty can be integrated into social decision-making processes by applying continuous-time decision theory and asset pricing tools.
• The interaction between climate and economic modelling uncertainties significantly increases the SCC.
• Climate and economic uncertainties have a multiplicative effect, leading to a substantial impact when both are large and acknowledged.
• Addressing ambiguity over models and the potential for model misspecification should be required to ensure accurate social valuation in various settings when assessing the economic impacts of climate change.
• As a simplistic application, the SCC can be used to identify which components of uncertainty are most impactful under specified conditions.

The framework outlined in the study accounts for model uncertainty and misspecification, allowing for a comprehensive evaluation of climate change's economic consequences.

This approach may serve as a foundation for developing richer economic models that can better address climate change mitigation and the development of green technologies.

The simplified climate and economic models used may underestimate the importance of nonlinearities in climate dynamics. This suggests room for further research, particularly in understanding climate tipping points and their economic implications.