Risk, Uncertainty and the Economics of Climate Change: Research Frontiers and Opportunities

1. Risk, Uncertainty and the Economics of Climate Change: Research Frontiers and Opportunities Prof. Charles D. Kolstad University of California, Santa Barbara and Resources for the Future WSWC/CDWR Climate Change Research Needs Workshop, Irvine, May 17, 2007

2. Structure of Presentation • Part I • Remarks on Risk and Uncertainty in Climate • Part II • Remarks on research frontiers in economics of climate change UCSB Bren School of Environmental Management

3. Risk, etc UCSB Bren School of Environmental Management

4. Just what are we talking about? • Uncertainty vs. Risk • Risk – we sort of understand the probabilities (eg, hurricanes in the Gulf) • Uncertainty – we don’t really even understand how likely or unlikely things are (eg, shut down of Gulf Stream). Most climate consequences. • Abrupt change: regime shift, something new happens quickly, gets out of hand, snowballs – chaotic • Catastrophe: something really big happens, though perhaps slowly, perhaps quickly (eg, sea level creeps up at 1 meter a decade, steadily) UCSB Bren School of Environmental Management

5. Size of Consequences Snowballiness Real Uncertainty (not risk) Good: close to origin Bad: far from origin UCSB Bren School of Environmental Management

6. Just what are we talking about II? • Physical changes • Gulf stream shutdown • Ice Sheet collapse • Economic disruptions from small physical changes • Infrastructure overload • Financial markets collapse • Mass migration • Social and Political Crises from small physical changes • Wars over resources (eg, Pakistan-India) UCSB Bren School of Environmental Management

7. “There are known knowns: there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns — the ones we don't know we don't know." -Donald Rumsfeld, Feb 2003 Rumsfeld on Uncertainty UCSB Bren School of Environmental Management

8. Frank Knight’s TypologyRisk and Uncertainty in Economics • Three kinds of probabilities (Knight, 1921) • Clear objective ones like the flip of a coin • Statistical ones like the probability of rain in September in Santa Barbara • Estimated ones like the probability of THC shutdown from a 3o global temperature rise (where there is no basis for statistical estimates) • We can get a handle on the first two • BUT, some things are just not knowable from direct statistical observation (“non-ergodic theorem”) UCSB Bren School of Environmental Management

9. Climate Change: What can be done? • Mitigation • Slow additions to atmosphere of GHG • Take action to sequester carbon • Adaptation • Private – individuals and firms take action to reduce vulnerability and impact from change • Public – infrastructure change in anticipation • Learning • Invest in better understanding the problem • Encourage R&D into carbon saving technologies UCSB Bren School of Environmental Management

10. Climate Risk and Uncertainty:What can be done? • Insurance markets (good for risk, not uncertainty) • Some risks insurable (require risk pooling) • Flood risk • Problems • Risks not always well known or well defined with changing climate • Reinsurers vulnerable • Market distortions an obstacle (Federal Flood Insurance, state regulation) • Derivative markets (better for uncertainty) • Catastrophe bonds • Pay off in certain well defined states of the world • Eg, Pay if Category 5 hurricane hits downtown New Orleans in 2006 pays $1 • Market price of 20¢ with people on both sides  20% market probability • Both sides of market involved • Risk pooling not necessary • Allows hedging of risk but doesn’t eliminate damage from change • Insurance and derivatives do not undo damage, only hedge risk • Mitigation and adaptation reduce damage UCSB Bren School of Environmental Management

11. Economics of Climate ChangeWhy do research in this area? • Pluses • Problem of immense import in the world (regardless of views on the seriousness of the issue) • Economics is at the center of the debate on what to do about climate change (essentially costs vs. benefits). • Comparatively few people work on the economics of climate change • Minuses • Many of the “economic issues” have little economics research content – mostly routine application of economic methods to develop estimates of damages or costs UCSB Bren School of Environmental Management

12. Economics of Climate ChangeResearch Needs • Need for long-term basic research to improve our set of tools • NSF-type support • Need for support for applications of economics to real-world decision problems • Work with BuRec, CDWR, others to develop tools to help with management decisions • Most of all: need to support capacity building so that there are more talented people working in these areas • More researchers • Encourage smart young people to go into the field UCSB Bren School of Environmental Management

13. Subcategories of Climate Economics • Damage estimation • Adaptation characterization • Cost estimation • Regulation • International agreements • Integrated assessment and policy models • Technical change • Discounting and intertemporal issues • Uncertainty and knowledge acquisition • Others??? UCSB Bren School of Environmental Management

14. Subcategories of Climate Economics • Damage estimation • For Example: what are the losses from drought in California? • Clear need for better and more comprehensive estimates of damage, both at aggregate and regional levels. • Desirable to develop methods based on historic data and econometrics (as opposed to speculative modeling about the future) UCSB Bren School of Environmental Management

15. Subcategories of Climate Economics • Damage estimation • Adaptation characterization • For example: How will agriculture in the central valley be able to adapt to reduced water flow from Sierra? How will cropping respond to reduced water availability? • Adaptation is emerging as a major issue • Problem of how to measure costs and extent of adaptation • Primarily an economic response to changed circumstances • Theoretical and empirical work needed to characterize adaptation process and investment in defensive expenditures UCSB Bren School of Environmental Management

16. Subcategories of Climate Economics • Damage estimation • Adaptation characterization • Cost estimation • For example: what are the costs to the state of reducing emissions from the transport sector? • Cost of mitigation important though not too exciting • Methods for estimating mitigation costs from historic data most useful UCSB Bren School of Environmental Management

17. Subcategories of Climate Economics • Damage estimation • Adaptation characterization • Cost estimation • Regulation • For example: What options are available to CARB? What can be done to manage a long-term reduction in water available to State? • Opportunity to develop innovative regulatory tools based on advances in economics of regulation – decentralized methods of promoting public good • Improved understanding of existing regulatory experiments (eg, ETS) UCSB Bren School of Environmental Management

18. Subcategories of Climate Economics • Damage estimation • Adaptation characterization • Cost estimation • Regulation • International agreements • For example: forging the post-Kyoto framework • Theory hampered by computational complexity • More realistic models of agreements desired • Truth testing with empirical analysis highly desirable UCSB Bren School of Environmental Management

19. Subcategories of Climate Economics • Damage estimation • Adaptation characterization • Cost estimation • Regulation • International agreements • Integrated assessment and policy models • For example: develop a model of California that can assess the distributional impacts of regulatory proposals. • Big demand for policy assessment models for evaluating the likely impact of proposed regulatory regimes • Continues to be demand for high level integrated assessment models for gaining insight into overall problem – simplicity and some realism UCSB Bren School of Environmental Management

20. Subcategories of Climate Economics • Damage estimation • Adaptation characterization • Cost estimation • Regulation • International agreements • Integrated assessment and policy models • Technical change • For example: can we expect LED’s to replace CFL’s in home lighting? • Remains a very important but poorly understood dimension of climate policy • Induced technical change particularly poorly understood. • Requires theoretical and empirical advances UCSB Bren School of Environmental Management

21. Subcategories of Climate Economics • Damage estimation • Adaptation characterization • Cost estimation • Regulation • International agreements • Integrated assessment and policy models • Technical change • Discounting and intertemporal issues • Issue of slow or hyperbolic discounting remains important for cost-benefit analysis of climate policy • This is a long term issue that is unlikely to go away UCSB Bren School of Environmental Management

22. Subcategories of Climate Economics • Damage estimation • Adaptation characterization • Cost estimation • Regulation • International agreements • Integrated assessment and policy models • Technical change • Discounting and intertemporal issues • Uncertainty and knowledge acquisition • Example: BuRec water management in Colorado • Uncertainty plagues climate problem • Are there institutional mechanisms for dealing with uncertainty (eg, derivative or insurance markets)? • Theoretical advances? UCSB Bren School of Environmental Management

23. Subcategories of Climate Economics • Damage estimation • Adaptation characterization • Cost estimation • Regulation • International agreements • Integrated assessment and policy models • Technical change • Discounting and intertemporal issues • Uncertainty and knowledge acquisition • Others??? UCSB Bren School of Environmental Management

24. Conclusions • There are needs for applied tools to help decision-makers deal with climate • There are also long-term needs for basic social science research (particularly economics) to help provide the methods and tools for decision-support • There is also a need for capacity building. Current incentives in economics are NOT to go into environmental economics and climate. UCSB Bren School of Environmental Management