Economic Modeling of Climate Risks

Abstract

Climate change is a subject that has been largely addressed from both macroeconomic and energetic standpoints. Integration of climate variables and natural capital into the traditional economic framework can appear conflicting with the notion of infinitely growing economies exploiting finite resources, which questions the sustainability of neoclassic economic growth models. Moreover, the temporal dimension is of paramount importance and the integration of inter-temporal utility is not a trivial issue. The construction of complex general equilibrium models is a way to model the response of economic systems to shocks.

Their use is somewhat limited because of their lack of transparency, computational scaling issues and non-equal attitudes toward uncertainty. If they are properly calibrated to model scenarios of interest, these models can however constitute an additional module for assisting short- and medium-term decisions. The dynamic integrated climate economy (DICE) seminal model of William Nordhaus allows to set an optimal global control trajectory with respect to a set of constraints and assumptions. Similar and more sophisticated macroeconomic models can provide the optimal allocation with respect to long-term constraints. The complexity of the academic literature might have clouded a rather simple question. Will we efficiently reduce the negatives implied by our economic activity or face the consequences? Consequently, the two aspects an investor wishes to assess is to what extent his portfolio contributes to the reduction of social and environmental negatives, and how it contributes to the improvement of global resiliency. The first dimension can be approached with integrated assessment models (IAMs) similar to the DICE, with clear and fair expression of trajectories required from each sector and region.

The remaining pitfalls are to set commonly accepted abatement cost curves and to obtain full disclosure of the research and development investment dedicated to climate change and to set issuer-specific deviation from the optimal path. Similarly, commonly accepted accounting techniques are required to meet this goal. Regarding the second dimension and the question of adaptation, there is a lack of behavioral modeling and indicators of the resiliency dimension where huge uncertainty remains and will not be dealt without the consideration of the social dimension.