The Role of Uncertainty in the Economics of Catastrophic Climate Change

Using climate change as a prototype motivating example, this paper analyzes the implications of structural uncertainty for the economics of catastrophes. The paper shows that having an uncertain multiplicative parameter, which ampli…es or scales exogenous impulses and is updated by Bayesian learning, induces 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. Under strict relative risk aversion, the impact of an uncertain scale of damages on cost-bene…t analysis outweighs the impact of discounting.