On Modeling and Interpreting the Economics of Catastrophic Climate Change

With climate change as prototype example, this paper analyzes the implications of structural uncertainty for the economics of low-probability high-impact catastrophes. Even when updated by …nite Bayesian learning, uncertain structural parameters induce a critical “tail fattening” of posterior-predictive distributions, Such fattened tails have strong implications for situations, like climate change, where a catastrophe is theoretically possible because prior knowledge cannot place su¢ ciently narrow bounds on overall damages. The core problem is learning extreme-impact tail probabilities from …nite data. Fat-tailed structural uncertainty, along with great unsureness about high-temperature damages, can outweigh discounting in climate-change economics. What is the abstract analytical essence of the economic problem posed by climate change? The economic uniqueness of the climate-change problem is not just that today’s decisions have di¢ cult-to-reverse impacts that will be felt very far into the future, thereby straining the concept of time discounting and placing a heavy burden on the choice of an interest rate. Nor does uniqueness come from the unsure outcome of a stochastic process with known structure and known objective-frequency probabilities. Much more unsettling for an application of (present discounted) expected utility analysis is deep structural uncertainty in the science of global warming coupled with an economic inability to place a meaningful upper bound on catastrophic losses from disastrous temperature changes. The climate science seems to be saying that the probability of a system-wide disastrous collapse is non-negligible –even while this tiny probability is not known precisely and necessarily involves subjective judgements. Thanks to Frank Ackerman, Roland Benabou, Richard Carson, Daniel Cole, Stephen DeCanio, Don Fullerton, Olle Häggström, Robert Hahn, John Harte, Peter Huybers, Reto Knutti, Karl Löfgren, Michael Mastrandrea, Robert Mendelsohn, Gilbert Metcalf, William Nordhaus, Cedric Philibert, Robert Pindyck, Richard Posner, John Reilly, Daniel Schrag, Cass Sunstein, Richard Tol, Gary Yohe, and Richard Zeckhauser.