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On discounting non-marginal policy decisions and cost-benefit analysis of climate-change policy

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Monetary valuation of climate-change impacts, and the cost-benefit analysis of climate-change policy into which it feeds, has long been controversial. Writers in ecological economics have done much to illuminate its difficulties. For the purposes of this paper, the key difficulties of the cost-benefit approach are, first, discounting future costs and benefits at comparatively high rates, second, the often implicit assumption of perfect substitutability between natural capital and other forms of capital and, third, the treatment of uncertainty, much of which is very difficult to quantify in this case. On the other hand, alternative approaches to climate-change policy based on safe minimum standards are not without their weaknesses either. They are largely arbitrary and, as a result, arguably more politically unstable. Thus the in-principle need for cost-benefit analysis will not diminish. In this paper, we consider how to develop the theory and practice of cost-benefit analysis as applied to climate-change policy, with a keen eye on its main weaknesses. This in particular demands that we look closely at the theory of inter-temporal aggregation: of discounting. We present an expected-utility approach to cost-benefit analysis. Our central premise is simple: given that unabated greenhouse gas emissions could potentially entail large, irreversible costs on the global economy and on welfare (formally, if the impacts of climate change are non-marginal), the simplified approaches to cost-benefit analysis and discounting practised in project appraisals the world over are inadequate. Instead, an expected-utility approach is required that calculates utility integrals along a range of possible paths. Expected utility must be calculated separately along business-as-usual paths compared to stabilisation paths, or else significant errors could be induced in the estimation of costs and benefits. This in turn requires that we find alternative ways of expressing the present value of the total and marginal costs of greenhouse gas emissions. We use the PAGE2002 integrated assessment model to develop some of our theoretical contribution empirically.

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