Why uncertainty matters: discounting under intertemporal risk aversion and ambiguity

Abstract

Uncertainty has an almost negligible impact on project value in the standard economic model. I show that a comprehensive evaluation of uncertainty and uncertainty attitude changes this picture fundamentally. The illustration of this result relies on the discount rate, which is the crucial determinant in balancing immediate costs against future benefits, and the single most important determinant of optimal mitigation policies in the integrated assessment of climate change. First, the paper removes an implicit assumption of (intertemporal or intrinsic) risk neutrality from the standard economic model. Second, the paper introduces aversion to non-risk uncertainty (ambiguity). I show a close formal similarity between the model of intertemporal risk aversion, which is a reformulation of the widespread Epstein–Zin–Weil model, and a recent model of smooth ambiguity aversion. I merge the models, achieving a threefold disentanglement between risk aversion, ambiguity aversion, and the propensity to smooth consumption over time.