Social Welfare Functions in Global Climate-Economy Models: Methodological Inconsistencies and their Policy Implications

Abstract

This paper reviews the application of social welfare functions (SWFs) in welfare-maximizing climate policy analysis. We identify several methodological inconsistencies, analyze their policy implications, discuss the theoretical questions raised by them, and provide recommendations for future studies. Our review finds that several SWFs applied in climate policy analysis are internally inconsistent. In particular, different methods for calculating the present values of alternative policy options lead to vastly different cost estimates. This topic has not been discussed in the literature despite the large attention that the discounting problem has generally received in the climate change context. The close link with the index number problem implies that there is no single 'correct' method for comparing the present values of alternative climate policies or other long-term policies involving significantly different economic trajectories. We also find that the uncritical combination of different SWFs can lead to erroneous results since they aggregate differently across time, population groups, states of the world, and components of economic output. We conclude that the translation of non-monetary welfare differences into monetary units is not generally possible. In particular, we show that no discounting scheme for certainty equivalents is consistent with expected discounted utility, which limits the use of certainty equivalents to account for risk aversion in intertemporal problems. Finally, we provide recommendations for avoiding the problems identified here in future climate policy analysis and show how the disregard of these recommendations in some recent studies has lead to artefactual results.