Fat Tails, Thin Tails, and Climate Change Policy

Robert Pindyck

Review of Environmental Economics and Policy, 2011, vol. 5, issue 2, 258-274

Abstract: Climate policy is complicated by the considerable uncertainties concerning the benefits and costs of abatement. We do not even know the probability distributions for future temperatures and impacts, making benefit--cost analysis based on expected values challenging to say the least. There are good reasons to believe that those probability distributions are fat-tailed, which implies that if social welfare is based on the expectation of a constant relative risk aversion utility function, then we should be willing to sacrifice close to 100 percent of gross domestic product to reduce greenhouse gas emissions. I argue that unbounded marginal utility makes little sense and that once we put a bound on marginal utility, this implication of fat tails goes away: Expected marginal utility will be finite even if the distribution for outcomes is fat-tailed. Furthermore, depending on the bound on marginal utility, the index of risk aversion, and the damage function, a thin-tailed distribution can actually yield a higher expected marginal utility (and thus a greater willingness to pay for abatement) than a fat-tailed one. Copyright 2011, Oxford University Press.

Date: 2011
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Working Paper: Fat Tails, Thin Tails, and Climate Change Policy (2010)
Working Paper: Fat Tails, Thin Tails, and Climate Change Policy (2010)
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