The Climate's Beta: An Estimation of the Consumption Beta on the Climate, Estimated with the Dynamic Integrated Climate-economy Model

Abstract

This thesis aims at estimating a consumption beta on the climate by means of the Dynamic Integrated Climate-Economy (DICE) model. We prove analytically and explain intuitively that the co-movement of benefits from climate change initiatives and aggregate consumption is the Consumption CAPM-beta on the climate. Inspired by the methodology of Dietz et al. (2018), we employ the DICE model to estimate the benefits from a marginal emissions abatement project on added consumption. By introducing uncertainty to parameters in the growth of Total Factor Productivity (TFP), we are able to estimate the effect on benefits and consumption, and thereby calculate the climate’s consumption beta. We also examine the effect of different specifications of the income elasticity of damages on beta, i.e. whether damages are proportional to output or not and how this influences the values of the climate beta. We find evidence for a positive climate beta, which is larger than the one obtained by Dietz et al. (2018) and currently applied in the DICE model by Nordhaus and Sztorc (2013); Nordhaus (2017b). Our findings suggest that when the main source of uncertainty is in the growth rate of TFP, the climate beta is positive for the whole time period of approximately 500 years in all cases but one. This result holds regardless of whether we model uncertainty through the initial growth rate of TFP, or by imposing transitory shocks to the growth rate. When damages are additive and uncertainty comes through the initial growth rate of TFP, we find that the beta becomes negative around year 2320. We depart from the methodology of Dietz et al. (2018) by allowing the savings rate to be endogenous and by employing a different definition of a marginal abatement project. Furthermore, we use the latest version of Nordhaus’ DICE model, which extends over a longer time period and incorporates the latest calibrations of the model’s parameters to empirical data. Lastly, we use one of the most recent estimates of long-run economic growth forecasts as the basis for modelling parametric uncertainty. Our findings show that there should be a positive risk-premium placed on top of the risk-free discount rate, to calculate the Net Present Value (NPV) of climate change investments. However, this result does not necessarily mean that the NPV of abatement projects will decrease in cost-benefit analysis (CBA). As shown by Dietz et al. (2018), expected benefits may also increase in the climate beta. The overall NPV of the climate mitigation projects is thus increasing in beta whenever the expected value effect is larger than the discounting effect. We contribute to the debate around the evaluation of uncertain climate mitigation projects through our novel way of estimating the climate beta. This gives valuable insights to policymakers around the world, possibly suggesting that climate change mitigation should be valued higher than the current norm implies. If the estimation of the climate beta obtained by us is correct and the present value of climate mitigation projects increase in the climate’s beta, then mitigation projects may be heavily undervalued and the social cost of carbon is thus higher than assumed today. The realization of this to policy makers may have large consequences for the choices of climate policies and mitigation projects that are undertaken.