Wednesday, 13 August 2008

Risk and climate change policy

Just before I went away Paul Krugman posted on the economics of catastrophe, and I have been meaning to follow up for a while. Krugman picks up on some research by Marty Weitzman looking at the distribution of outcomes of climate change. The basic idea is to look at the uncertainties and hence come up not just with a single prediction of the path of global average temperatures, but a path of distributions. There is a lot of model risk in this analysis - it is bad enough predicting financial distributions were we do at least have a lot of high frequency data - however the results are interesting. Krugman says:
Marty surveys the existing climate models, and suggests that they give about a 1% probability to truly catastrophic change, say a 20-degree centigrade rise in average temperature.
Twenty degrees would be game over. Even if it is only 0.01% chance, this is an outcome worth hedging. Clearly then it is not just the expected temperature change that we should be concerned with, it is the variance of that change, or more accurately the upside tail of the distribution. As Krugman says, mobilizing people to protect against low probability but catastrophic outcomes is crucial. Hedging far from the money is cheap, but you do actually have to buy those options.

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