Adapted from “Carbon Dioxide as a Risky Asset,” by Adam Michael Bauer of the University of Illinois, Cristian Proistosescu of the University of Illinois, and Gernot Wagner of Columbia Business School
Key Takeaways:
- The new model categorizes carbon mitigation as risk management rather than an investment, going against prominent climate-economic models.
- By applying this logic, the study shows the carbon price is higher in the near future and decreases over time. This is the opposite of the trend traditional models predict, which imagine climate change as a problem mainly impacting the future, with the carbon price rising over time accordingly.
- The model demonstrates the need for rapid carbon mitigation.
In 1992, Yale’s William Nordhaus published the Dynamic Integrated Climate-Economy model (or DICE model), one of the first integrative assessment models (IAMs) to illustrate the interplay between the economy and various aspects of climate change and to calculate the societal costs of carbon emissions. Since then, the Nobel Prize–winning DICE model and other IAMs have formed the basis for much of climate economic research. The area of study is essential for providing a framework for climate policy discussions as companies and governments weigh the costs and benefits of climate mitigation.
This new study by Professor Gernot Wagner, a senior lecturer in the discipline of economics at Columbia Business School, contributes to the body of climate economic research with a new IAM, applying financial economics to climate science. “Financial economists approach asset pricing very differently from the standard climate economic approach,” Wagner says. “This paper is not the first but, I like to think, the latest and greatest attempt of applying financial logic to climate economic thinking.”
How it was done: Wagner and his co-authors, both of whom are climate scientists, used data from the Intergovernmental Panel on Climate Change’s (IPCC) sixth assessment report to run a financial-economic analysis on the impact of the climate crisis. “We are using financial logic — precisely the logic that one would use to hedge any other risk,” Wagner says, and then applying that logic to hedging climate risk.
According to Wagner, when it comes to climate mitigation, rather than looking at the potential for returns on investment, it is more logical to compare mitigation efforts to homeowners insurance: You’re not looking for a return; you’re looking to protect yourself in the worst-case scenario. “How do you ever justify spending money on avoiding the worst possible outcome?” Wagner says. “You figure out that climate is a risk management problem. It's not about the average payoff of your investment in cutting emissions — it’s about avoiding risk.” The researchers’ new IAM uses that logic to reimagine how we assess climate action.
What the researchers found: The result is a financial-economic model for carbon pricing with a focus on decision-making under risk and uncertainty that is consistent with the IPCC’s sixth assessment report. Because it uses a different logical basis than other IAMs, some core features are reversed — most notably, the cost of carbon.
“It starts high and decreases over time, which is pretty much the opposite of how we typically think about this,” Wagner says. The typical climate-economic tradeoff thinking, he says, is that climate is a problem, but its damage primarily affects future generations while the costs of cutting emissions impact us today. So, when it comes to mitigation, the thinking may be, “OK, we're going to start low and increase ambition over time because you don't want to hit people over the head with this immediately,” he says. “You want to go slow.” This version of climate cost modeling would change that approach.
Why it matters: The new model provides evidence for a more stringent mitigation of carbon emissions in the near future. By treating carbon as a “risky asset” and calculating the cost and associated abatement policy, the model shows policy should limit warming to around 1.5 degrees Celsius by 2100, which is in line with the Paris Agreement’s targeted warming limit. Practically speaking, this means cutting more than 70 percent of emissions “in relatively short order,” the study says.
The idea is, more spending on climate mitigation right now may reduce our risk in the long run. To illustrate the current climate change situation, Wagner uses the “Boots” theory in socioeconomics: A rich person buys high-quality, expensive boots that last a decade while a poor person buys cheaper boots yearly and winds up paying more in 10 years and “still has wet feet.”
Wagner acknowledges the impediments to spending money on carbon mitigation in the near term, like many people being unable to pay the upfront cost of electric vehicles, even though the savings of owning and operating the EV will far outpace its gas-powered competitors over time. “That logic makes sense, but only when you think about the reasons why we don't want to invest right now,” he says. “What our paper shows is that, while those reasons exist, they ought not be a consideration when it comes to actually designing ‘optimal policy.’”
