Environmental Protection, Rare Disasters, and Discount Rates

Robert J. Barro

NBER Working Paper No. 19258
Issued in July 2013
NBER Program(s):   AP   EEE   EFG   PE

Extremely low discount rates play a central role in the Stern Review's evaluation of environmental protection, and this assumption has been criticized by many economists. The Review also stresses that great uncertainty is a critical element for optimal environmental policies. An appropriate model for this policy analysis requires sufficient risk aversion and fattailed uncertainty to get into the ballpark of explaining the observed equity premium. A satisfactory framework, based on Epstein-Zin/Weil preferences, also separates the coefficient of relative risk aversion (important for results on environmental investment) from the intertemporal elasticity of substitution for consumption (which matters little). Calibrations based on existing models of rare macroeconomic disasters suggest that optimal environmental investment can be a significant share of GDP even with reasonable values for the rate of time preference and the expected rate of return on private capital. The key parameters, yet to be pinned down, are the proportionate effect of environmental investment on the probability of environmental disaster and the baseline probability of environmental disaster.

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Document Object Identifier (DOI): 10.3386/w19258

Published: Environmental Protection, Rare Disasters and Discount Rates Robert J. Barro Article first published online: 27 NOV 2014 Economica Volume 82, Issue 325, pages 1–23, January 2015

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