The interplay between risk attitudes and low probability, high cost outcomes in climate policy analysis

Abstract

Assessing the value of climate change mitigation requires an analysis framework that can account for society's attitude toward the risk of uncertain outcomes, especially those with low probability and high cost. For largely historical and computational reasons, this issue has not been adequately addressed by previous climate policy analyses. Using a novel stochastic version of a tractable global climate model, we demonstrate the importance of this shortcoming by showing how low probability, high cost outcomes interact strongly with risk attitudes to shape the results of quantitative analysis. Our results indicate that the relatively high levels of risk aversion implied by global investment behavior suggest that the large downside risk of economic catastrophe should weigh more heavily in policy consideration than the risk of over-mitigation. Further, this qualitative conclusion is robust to the particular specification of uncertainties concerning climate sensitivity and resultant economic damages. This conclusion is at odds with previous analyses that either assume low levels of risk aversion or employ numerical methods that underestimate disaster probabilities and therefore imply that the risk of over-mitigation should be of primary concern. This divergence suggests that more attention should be paid to the specification of risk attitudes and risk exposure in climate policy analysis.