Discounting the Future: On Climate Change, Ambiguity Aversion and Epstein–Zin Preferences

Abstract

We show that ambiguity aversion and 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. We analyze the impact of substitution preferences, risk aversion (known probabilities), and ambiguity aversion (unknown probabilities) on the social cost of carbon. Introducing ambiguity aversion leads to two offsetting effects on the social cost of carbon: a positive direct effect and a negative effect through discounting. Our numerical results show that for reasonable calibrations, the direct effect dominates the discount rate impact, so ambiguity aversion gives substantially higher estimates of the social cost of carbon.