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Environmental Protection and Rare Disasters

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Published on Mar 25, 2014

Speaker: Professor Robert J Barro
Chair: Professor Sir Christopher Pissarides

Recorded on 20 March 2014 in Old Theatre, Old Building.

The Stern Review's evaluation of environmental protection relies on extremely low discount rates, an assumption criticized by many economists. The Review also stresses that great uncertainty is a critical element for optimal environmental policies. An appropriate model for this policy analysis requires sufficient risk aversion and fat-tailed uncertainty to get into the ballpark of explaining the observed equity premium. A satisfactory framework, based on Epstein-Zin/Weil preferences, also separates the coefficient of relative risk aversion (important for results on environmental investment) from the intertemporal elasticity of substitution for consumption (which matters little). Calibrations based on existing models of rare macroeconomic disasters suggest that optimal environmental investment can be a significant share of GDP even with reasonable values for the rate of time preference and the expected rate of return on private capital. Optimal environmental investment increases with the coefficient of relative risk aversion and the probability and typical size of environmental disasters but decreases with the degree of uncertainty about policy effectiveness. The key parameters that need to be pinned down are the proportionate effect of environmental investment on the probability of environmental disaster and the baseline probability of environmental disaster.

Robert J Barro is Paul M Warburg Professor of Economics at Harvard University and a senior fellow of the Hoover Institution of Stanford University.

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