Epstein-Zin utility in DICE: Is risk aversion irrelevant to climate policy?

Climate change involves uncertain probabilities of catastrophic risks, and very long-term consequences of current actions. Climate economics, therefore, is centrally concerned with the treatment of risk and time. Yet conventional assumptions about utility and optimal economic growth create a perverse connection between risk aversion and time preference, such that more aversion to current risks implies less concern for future outcomes, and vice versa.

The same conflation of risk aversion and time preference leads to the equity premium puzzle in finance. A promising response to the equity premium puzzle, the recursive utility of Epstein and Zin, allows separation of risk aversion and time preference – at the cost of considerable analytic complexity.

Using Epstein-Zin parameters from the finance literature and climate uncertainty parameters from the science literature, the authors find that the optimal climate policy in EZ-DICE calls for rapid abatement of carbon emissions; it is similar to standard DICE results with the discount rate set to equal the risk-free rate of return.

EZ-DICE solutions are sensitive to the intertemporal elasticity of substitution, but remarkably insensitive to risk aversion. Insensitivity to risk aversion may reflect the difficulty of modeling catastrophic risks within DICE. Implicit in DICE are strong assumptions about the cost of climate stabilization and the certainty and speed of success; under these assumptions, risk aversion would in fact be unimportant. A more realistic analysis will require a subtler treatment of catastrophic climate risk.

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