Dsge Climate Change

Introduction DICE DSICE Uncertain Climate Change & Discounting Conclusion
DSICE - Dynamic Stochastic General Equilibrium

Analysis of Climate Change Policies and
Discounting
Yongyang Cai
(Hoover Institution)
Kenneth L. Judd
(Hoover Institution)
Thomas S. Lontzek
(University of Zurich)
July 29, 2011

Yongyang Cai (Hoover Institution) Kenneth L. Judd (Hoover Institution) Thomas S. Lontzek (University of Zurich)
DSICE - Dynamic Stochastic General Equilibrium Analysis of Climate Change Policies and Discounting
I All IAMs (Integrated Assessment Models) are deterministic
I Most are myopic, not forward-looking
I This combination makes it impossible for IAMs to consider decisions in

a dynamic, evolving and uncertain world
I We formulate dynamic stochastic general equilibrium extensions of

DICE (Nordhaus)
I Conventional wisdom: Integration of DSGE models with long run

intertemporal models like IGEM is beyond the scientific frontier at the
moment (Peer Review of ADAGE and IGEM, June 2010)
I Fact: We use multidimensional dynamic programming methods,

developed over the past 20 years in Economics, to study dynamically
optimal policy responses
Todays Presentation
I Fix DICE
I Introduce DSICE
I Apply DSICE to ask what is optimal policy when faced with potential
tipping points?
I DICE: maximize social utility subject to economic and climate

constraints

X
max ct ,lt ,t t u(ct , lt )
t=0
s.t. kt+1 = (1 )kt + t (1 t )Yt ct ,

Mt+1 = M Mt + (Et , 0, 0)> ,
Tt+1 = T Tt + (1 Ft , 0)> ,
I output: Yt f (kt , lt , t) = At kt lt1

1
I damages: t 1+1 TtAT +2 (TtAT )2
I emission control effort: t 1
t
2
1,t t 2
I Mass of carbon concentration: Mt = (MtAT , MtLO , MtUP )>
I Temperature: Tt = (TtAT , TtLO )>
I Total carbon emission: Et = EInd,t + ELand,t , where
EInd,t = t (1 t )(f1 (kt , lt , t , t))
I Total radiative forcing (watts per square meter from 1900):
Ft = log2 (MtAT /M0AT ) + FtEX
I DICE analysis
I 10 year time periods
I First, we compare the deterministic case to Nordhaus DICE model
I Strange finite-difference scheme for dynamics, incompatible with any
method in the numerical literature
I We build a 10-year and 1-year period length model, and find Nordhaus
approach is unreliable:
4 Capital Stock
x 10
12
N10
CJL10
10 CJL4
CJL2
CJL1
0
0 100 200 300 400 500 600
Year
Temparature of Atmosphere
4.5
N10
CJL10
4 CJL4
CJL2
CJL1
3.5
2.5
1.5
0.5
0 100 200 300 400 500 600
Year
Carbon in Atmosphere
1700
N10
CJL10
1600
CJL4
CJL2
1500 CJL1
1400
1300
1200
1100
1000
900
800
0 100 200 300 400 500 600
Year
Emission Control Rate

0.7
N10
CJL10
0.6 CJL4
CJL2
CJL1
0.5
0.4
0.3
0.2
0.1
0
0 50 100 150
Year
Carbon Tax
400
N10
350 CJL10
CJL4
CJL2
300 CJL1
250
200
150
100
50
0
0 50 100 150
Year
Cai-Judd-Lontzek DSICE Model:

Dynamic Stochastic Integrated Model of Climate and Economy
DSICE = DICE 2007

constraint on savings rate , i.e. : s = .22
ad hoc finite difference method
+ stochastic production function
+ stochastic damage function
+ 1-year period length
stochastic means: intrinsic random events within the specific model, not
uncertain parameters
I DSICE: solve stochastic optimization problem

X
max ct ,lt ,t E t u(ct , lt )
t=0
s.t. kt+1 = (1 )kt + t (1 t )Yt ct ,

Mt+1 = M Mt + (Et , 0, 0)> ,
Tt+1 = T Tt + (1 Ft , 0)> ,
t+1 = g (t , t ),
Jt+1 = g J (Jt , Jt )

I Yt f (kt , lt , t , t) = t At kt lt1

Jt
I t 1+1 T AT+ 2 (T
AT )2 , t 1
t
2
1,t t 2
t t
I t : productivity shock, Jt : damage function shock

I DP model for DSICE :
Vt (k, , J, M, T ) = max u(c, l) + E[Vt+1 (k + , + , J + , M + , T + )]

c,l,
+
s.t. k = (1 )k + t (1 t )f (k, l, , t) c,
M +
= M M + (Et , 0, 0)> ,
T +
= T T + (1 Ft , 0)> ,
+ = g (, ),
J+ = g J (J, J )
Application: Uncertain climate change & discounting
I Standard assumption in DICE: damages are a function of

contemporaneous temperature
I However, many scientists are worried about triggering abrupt and

irreversible climate change
I Consequence: permanent and significant damage over a large time

horizon
I Abrupt climate change must be modeled stochastically
I How does optimal emission control policy respond to the threat of

abrupt and irreversible climate change?
I What is the appropriate discount rate?
hazard rate
I Lenton et al. (PNAS, 2008) characterize some major tipping elements

in the earths climate system:
Tipping Element key Impacts
Thermohaline circulation reg. sea level rise (1m)

collapse cool North Atl, warm south. ocean
West Antarctic ice sheet sea level (up to 5 m)

changes in El Nino Drought (e.g: SE Asia)
Southern Oscillation + El Nino frequency and persistence
Permafrost melting enhanced global warming due to

CH4 and CO2 release
Zickfeld et al. (2007, Climatic Change): Experts subjective probability (%)

that a collapse of THC will occur or be irreversibly triggered by 2100
I Kriegler et al. (PNAS, 2009) conduct an extensive expert elicitation on

some major tipping elements and their likelihood of abrupt change.
I THC collapse
I Greenland ice sheet melting
I WestAntarctic ice sheet melting
I Amazon rainforest dieback
I ElNino/Southern Oscillation
I They compute conservative lower bounds for the probability of

triggering at least 1 of those events
I 0.16 for medium (2 4 C ) global mean temperature change
I 0.56 for high (above 4 C ) global mean temperature change
We calculate (reverse engineer) the annual hazard rate of THC collapse as a

function of global mean temperature rise based on Zickfeld et al. (2007, Climatic
Change)
0.2
average optimistic expert

0.18
average pessimistic expert
0.16
0.14
annual hazard rate
0.12
0.1
0.08
0.06
0.04
0.02
0
1 1.5 2 2.5 3 3.5 4 4.5 5 5.5 6
T from preindustrial level
I The time of tipping is a poisson process
I Once the tipping point is reached the shock to the damage function
persists
I We assume a tipping point causes a permanent 10 % reduction in

output.
I Probability of a tipping point occurring at time t is equal to the hazard

rate as a function of temperature at t
I ht = 0.01 Tt T2000
I We simulate 1000 optimal paths
I We report mean, median and quartiles
I the Nordhaus (DICE) specification of

externality implies a rising emission control
rate
I intuition
I temperature is rising
I damage at time t is rising
I present value of damages is rising
I marginal benefit of emissions control is
rising
In RICE (Nordhaus, 2010 PNAS) seal level rise is a linear function of

current temperature and hence persistent. However, it is reversible and
deterministic.
DSICE has stochastic irreversible damages.
Emission Control Rate Deviation of Emission Control Rate
0.9 0.15
I red: 0 % and
0.8
0.1 100% quartiles
0.7
represent outer
0.6 0.05 envelopes of the
paths
0.5
0
0.4
I blue: 25% and
0.05 75% quartiles
0.3
0.2 0.1
I cyan: median
0.1 I black: expectation

0.15
of (average) at t
50 100 150 200 50 100 150 200
Stage Stage
0.9 0.15
I is higher if the
tipping has not yet
0.8
0.1 occurred
0.7
I the drop in after
0.6 0.05
the tipping
0.5
0
represents the
effort to delay
0.4
0.05 tipping
0.3
I the anti-tipping
0.2 0.1
effort is constant
0.1 over time even
0.15
though the danger
50 100 150 200 50 100 150 200
Stage Stage and costs are rising
0.9 0.15
0.8
0.1 I constant
0.7
anti-tipping effort
0.05
0.6 in the face of a
0.5
rising tipping
0
hazard implies a
0.4
low effective
0.05
0.3 discount rate, as is
0.1
the case with
0.2
insurance
0.1
0.15 expenditures.
50 100 150 200 50 100 150 200

Stage Stage
Difference of Emission Control Rate

0.25
10% Damage
2% Damage
1% Damage I sensitivity of
0.2
results to damage
factor
0.15 I optimal policy
towards tipping
applies a very
0.1
small discount rate
to future damage
0.05 from tipping
(insurance
analogy)
0
0 20 40 60 80 100 120 140 160 180
Year
Summary of Application
I DSICE is the first example of a stochastic IAM
I DSICE models tipping points where current temperature can have a
permanent damage effect on output
I DICE model damage function does not incorporate this kind of
externality which is in the nature of tipping points.
I DICE implies steeply rising emission control rates
I DSICE implies a constant effort to delay a catastrophe despite the
rising prob. of crossing a tipping point and higher expected damage as
percentage of GDP
I Policies towards catastrophes resemble insurance expenditures which
always have a negative return
Conclusion
I Stochastic IAM analysis with short time periods is tractable
I DSICE implies a constant effort to delay a catastrophe, not a ramp
I Including stochastic elements in climate and economics can

substantially effect policy results

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Introduction DICE DSICE Uncertain Climate Change & Discounting Conclusion

DSICE - Dynamic Stochastic General Equilibrium

July 29, 2011

I All IAMs (Integrated Assessment Models) are deterministic

I Most are myopic, not forward-looking

I This combination makes it impossible for IAMs to consider decisions in

I We formulate dynamic stochastic general equilibrium extensions of

I Conventional wisdom: Integration of DSGE models with long run

I Fact: We use multidimensional dynamic programming methods,

I DICE: maximize social utility subject to economic and climate

s.t. kt+1 = (1 )kt + t (1 t )Yt ct ,

I output: Yt f (kt , lt , t) = At kt lt1

I Mass of carbon concentration: Mt = (MtAT , MtLO , MtUP )>

I Temperature: Tt = (TtAT , TtLO )>

I Total carbon emission: Et = EInd,t + ELand,t , where

EInd,t = t (1 t )(f1 (kt , lt , t , t))

I Total radiative forcing (watts per square meter from 1900):

Ft = log2 (MtAT /M0AT ) + FtEX

Emission Control Rate

Cai-Judd-Lontzek DSICE Model:

DSICE = DICE 2007

I DSICE: solve stochastic optimization problem

s.t. kt+1 = (1 )kt + t (1 t )Yt ct ,

I t : productivity shock, Jt : damage function shock

I DP model for DSICE :

Vt (k, , J, M, T ) = max u(c, l) + E[Vt+1 (k + , + , J + , M + , T + )]

Application: Uncertain climate change & discounting

I Standard assumption in DICE: damages are a function of

I However, many scientists are worried about triggering abrupt and

I Consequence: permanent and significant damage over a large time

I Abrupt climate change must be modeled stochastically

I How does optimal emission control policy respond to the threat of

I What is the appropriate discount rate?

I Lenton et al. (PNAS, 2008) characterize some major tipping elements

Tipping Element key Impacts

Thermohaline circulation reg. sea level rise (1m)

West Antarctic ice sheet sea level (up to 5 m)

Southern Oscillation + El Nino frequency and persistence

Permafrost melting enhanced global warming due to

Zickfeld et al. (2007, Climatic Change): Experts subjective probability (%)

I Kriegler et al. (PNAS, 2009) conduct an extensive expert elicitation on

I They compute conservative lower bounds for the probability of

We calculate (reverse engineer) the annual hazard rate of THC collapse as a

average optimistic expert

I The time of tipping is a poisson process

I We assume a tipping point causes a permanent 10 % reduction in

I Probability of a tipping point occurring at time t is equal to the hazard

I We simulate 1000 optimal paths

I We report mean, median and quartiles

I the Nordhaus (DICE) specification of

In RICE (Nordhaus, 2010 PNAS) seal level rise is a linear function of

Emission Control Rate Deviation of Emission Control Rate

0.1 I black: expectation

Emission Control Rate Deviation of Emission Control Rate

Emission Control Rate Deviation of Emission Control Rate

50 100 150 200 50 100 150 200

Difference of Emission Control Rate

I Stochastic IAM analysis with short time periods is tractable

I DSICE implies a constant effort to delay a catastrophe, not a ramp

I Including stochastic elements in climate and economics can

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