Cost-benefit analysis and climate change compensation in developed economies

PRICING THE FUTURE, THE AMERICAN CLIMATE PROSPECTUS, and THE STERN REVIEW.

First, the global warming case. Please don't go crazy. You do not need to consult any other sources besides

You can probably do an adequate job of answering the questions in less than 10 pages, especially since I don't expect more than a few paragraphs on each question.

Do you consider cost-benefit analysis of the kind discussed above as a sensible approach to this problem? Why or why not? Include your thoughts about including environmental costs and the costs of reasonable compensation to developing economies.

This problem is so incredibly complex that any approach to try and get a sense of the scope of the problem is sensible. The scope of the problem is so large that it can generate a sense of apathy. Any approach that can overcome apathy and change people's behaviors should be welcomed. The cost-benefit approach however, should always be viewed with some skepticism since the potential a large margin of error in the estimates exists. However, the approach could be more accurate with individual choices rather than trying to aggregate the entire economy.

For example, you can easily conduct a cost-benefit approach to replacing a traditional light bulb with an LED light bulb and determine the payback period. The same methods can be applied to a variety of energy efficiency investments as well. However, the cost-benefit approach just isn't as accurate on a macro level.

In regards to compensating developing economies, the first world definitely has an obligation. For example, most of the carbon emissions that are stuck in the atmosphere today were from emission from the first countries to develop using fossil fuels. These emissions have a cumulative effect on climate change. Therefore, it is unfair to tell the third world that they cannot develop using the same means as the first world because it contributes to climate change. The majority of the emission were not created in third world but they are essentially being asked to pay the costs associated with sustainable development even though they were not responsible for the damages.

Yet, at the same time, even if the first world owes a debt to developing economies, the amount is certainly unclear. Most of the damage was done during previous generations. For example, a large percentage of the individuals most responsible for contributing to climate are no longer alive today; nor did they even understand the damage they were doing to the planet. Thus it is hard to hold the younger generations completely responsible for their ancestors mistakes. Therefore, there will undoubtedly have to be substantial compromises between the developing world and the developed world to come to an effective arrangement. Furthermore, since virtually everyone agrees that the costs increase as time goes on, the sooner a compromise can be reached the better.

After reviewing the discussions in Pricing the Future and the Stern Review, what do you think of their arguments in favor of a very small or even zero value for ?, the "impatience rate"? Justify your answers.

A very small impatience rate seems reasonable. There is some value to foregoing current consumption in order to make the future better in some manner. However, at the same time, respect for future generations seems like it should be dictated more by an ethical capacity. Thus, it is easy to see why this is such a hotly debated point.

After reviewing the discussions in Pricing the Future, the Stern Review, the American Climate Prospectus and any other sources you choose, what choices would you make for ?, the relative rate of risk aversion, and the growth rate, g? Justify your answers. I just want you to think about these questions and give me your opinions, with a few sentences of justification.

I believe that I would make the risk aversion rate higher than average and the growth rate lower. I believe that we should basically caution on the safe side relative to risk aversion given the levels of uncertainty that are inherent in climate models. Furthermore, I think we can develop in ways that are necessarily tied to economic growth and consumption. For example, we could move to more of a services-based economy that consumes less raw materials and finished goods.

Fill in the steps in the derivation of the Ramsey rule that are left out of Dupire's discussion. Start with the simplified utility function u (c0) + exp (-?t) u (ct), and explain what is done to optimize that utility

The impatience parameter is left out in this equation. This basically relates to how people typically prefer to consume things now rather than later. Thus to put off current consumption (cO) we should be compensated with higher levels of future consumption (ct). The ideal rate will balance the utilities that are found in both present and future consumption.

Repeat Dupire's fit of the global warming cost data in the table displayed in the section entitled "A Second Meeting." Use your choices of ?, ?, and g to compute the appropriate discount rate r, and compute the total present value of all of the yearly costs to the year 2100, the last year that we have cost estimates.

Determine the yields to maturity of a few bonds that mature around 2100. How do these yields compare with the discount rate, r, which you estimated in the previous question? How do the resulting present values compare? Can you account for the differences? When you do this comparison, make sure that you assume the same compounding frequency for both the bond yields and r. I can't reasonably expect precise answers here. For one thing, there is the problem of liquidity: many of these bonds don't trade very often, so you are not going to get very good estimates of their market prices, and thus their yields to maturity. But do the best you can. For example, compare the yields of shorter maturity bonds by the same issuer to treasuries of the same maturity. This will give you an idea of spreads due to default risk and liquidity. What about inflation?