The impact of possible climate catastrophes on global warming policy
Introduction
The increase of the greenhouse effect is probably the most important threat to our global environment and future. Therefore, it is not surprising that global warming has received considerable attention by the international community, leading to the United Nation's Framework Convention on Climate Change (UN FCCC), which came into effect in March 1994. The objective of the UN FCCC is “to achieve (...) stabilisation of greenhouse gas (ghg) concentrations in the atmosphere at a level that would prevent dangerous anthropogenic interference with the climate system”. (UN FCCC, Article 2). In 1997, the Kyoto Protocol was the first attempt to translate the UN FCCC's general objective into a precise policy commitment, by prescribing legally binding emissions targets for a group of industrialised countries and economies in transition.
Although the Kyoto Protocol was strongly influenced by political factors, the prudence of most countries in ratifying it may be justified in the light of the peculiar features of the global warming problem, such as large uncertainties, non-linearities and irreversibilities, possible catastrophes with small probabilities, asymmetric distribution of impacts, the very long planning horizon, and the global and public good characteristics of the problem (IPCC, 1996). Although solving for scientific uncertainties will not be possible in the near future, in recent years natural catastrophes, which could be related to climate change, have increased.
In this paper, we develop a model in which policy actions to limit greenhouse gas emissions and their optimal timing are influenced by two events. On the one hand, the costs of global warming arise from higher temperatures that will produce continuous damages over time. On the other hand, it cannot be excluded that the increase in temperature may produce sudden events in terms of climate catastrophes. The inherent problem is that there is considerable uncertainty associated with these two types of events, as indicated by current debates in the scientific and economic communities. To account for this double uncertainty, we propose to use the real option theory that has been popularised in the investment literature (see Pindyck, 1991; Dixit, 1992). Several authors have applied this approach to the global warming problem, but they have assumed, partly for analytical reasons, that the dynamics of damages are given by a continuous stochastic process (e.g., see Kolstad, 1995; Peck and Teisberg, 1993; Birge and Rosa, 1996; Hanemann, 1989; Schimmelpfennig, 1995; Baranzini et al., 1995). In our paper, costs and benefits associated with global warming follow a more general stochastic process: a mixed process (Brownian motion and Poisson process) which can be discontinuous over time. Such methodology has recently been developed in financial literature (See also Chesney et al., 2002) but, to our knowledge, has never been applied to the global warming issue. Our paper also differs from Nordhaus (1994) or Gjerde et al. (1999) that have either assumed that the catastrophic changes are known with certainty or have failed to include uncertain continuous costs.
The main advantage of our approach is that it is easily quantifiable in terms of policy actions. As an example to gain qualitative insights into our approach, we used the model developed by Cline (1992) and then provide indications on which abatement policy (and when) should be implemented in five different cases: (i) the net benefits are uncertain, but there is no risk of climate catastrophe, (ii) the net benefits are continuously uncertain and there is a risk of a US$30 billion climate catastrophe on average each year, (iii) the net benefits are continuously uncertain and there is a risk of a US$100 billion climate catastrophe on average each year, and (iv) the net benefits are continuously uncertain and there is a risk of a US$500 billion climate catastrophe on average once every 10 years. We compare our results with what is obtained with the classical cost–benefit analysis (CBA), in which the time value is not taken into account. The magnitude and the frequency of catastrophes can vary in the model, but we assume that those are determined exogenously. Of course, the methodology developed in this paper and the sensitivity of the results to changes in important parameters are more important than the numerical results, which should thus be interpreted qualitatively only.
The paper proceeds as follows. In Section 2 we review the basic theory of the real option model. Section 3 presents the results of a numerical application, based on Cline's (1992) CBA and integrating the real option model with discontinuities. Section 4 concludes and presents some qualifications.
Section snippets
The real option model
In economic terms, the global warming problem can be addressed through four interrelated questions (cf. Munasinghe et al., 1996): (i) By how much should ghg emissions be reduced? (ii) When should ghg emissions be reduced? (iii) How should emissions be reduced? (iv) Who should reduce emissions? The answers to these questions are particularly challenging, because of the complexity of the global warming problem, the large uncertainties associated with it and the possibility of catastrophic events.
A numerical application
The objective of this section is to apply the real option model detailed in the appendix. In doing so, we identify the impact of global warming on the decision process to implement or not implement a given abatement policy. In particular, we examine the sensitivity of the results to the following parameters (i) the presence or absence of uncertainty, and (ii) the presence or absence of climatic catastrophes, (iii) the presence of a series of small climate catastrophes with high frequency or of
Concluding remarks
Gradual uncertainty and the possibility of climate catastrophes are inherent to the global warming phenomena, and should be explicitly taken into account in the evaluation of abatement policies by scientists and policy-makers. Although the uncertainty regarding the scientific evidence of climate change remains one of the major concerns, economic analysis can provide some guidance on climate policies.
This paper has examined the impact of uncertainty and climate catastrophes on the optimal
Acknowledgements
The findings, interpretations, and conclusions are the authors’ own and should not be attributed to their institutions. Financial support to Andrea Baranzini by the Swiss National Centre of Competence in Research (NCCR) “Climate” is gratefully acknowledged. We thank an anonymous referee for helpful suggestions.
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