Risk and Return in Environmental Economics

Abstract

I examine risk/return trade-offs for environmental investments and their implications for policy choice. Consider a policy to reduce carbon emissions. To what extent should the policy objective be a reduction in the expected temperature increase versus a reduction in risk? Using a simple model of a stock externality that evolves stochastically, I examine the “willingness to pay” (WTP) for alternative policies that would reduce expected damages versus the variance of those damages. I compute “iso-WTP” curves (social indifference curves) for combinations of risk and expected return as policy objectives. Given cost estimates for reducing risk and increasing expected returns, one can compute the optimal risk-return mix for a policy, and the policy’s social surplus. I illustrate these results by calibrating the model to data for global warming.