Saturday, April 10, 2010

Come on! You don't give the same discount rate to insurance as stock, and that includes global warming insurance!

Paul Krugman recently had a long New York Times article on the economics of global warming. The vast majority of it was very good for laypeople, as you would expect from the great Nobel Prize winning economist, but this part I really didn't like:
The policy-ramp advocates [most notably William Nordhaus with his DICE model] argue...costs that far in the future should not have a large influence on policy today. They point to market rates of return, which indicate that investors place only a small weight on the gains or losses they expect in the distant future, and argue that public policies, including climate policies, should do the same...As a professional economist, I find this debate painful. There are smart, well-intentioned people on both sides — some of them, as it happens, old friends and mentors of mine — and each side has scored some major points.
This argument should not be given nearly this much respect. Krugman often chastises economists for not understanding things from intermediate undergrad econ. Well, the argument above shows a lack of understanding of finance 101, or at least an unwillingness to apply it on a societal level, or a lack of understanding of the significant catastrophic risks that are the consensus of the top climate scientists.

The rate of return demanded is dependent on the risk of an investment. You expect, and demand, the stock market rate of return for an investment that is as risky as the stock market portfolio, not for any investment. If the investment is less risky, then it's still a good deal even with a lower expected return. If the investment is even better than zero risk, that is if it decreases the existing risk you have, like insurance, then it can even be worth it even if it has a negative return.

And people practice this all the time. Almost everyone buys homeowners insurance or car insurance even though the expected return is negative, and this is the case even when it's not required by law or lender. The reason is that it's so decreasing of catastrophic risk that it's still well worth it. It's still considered a great investment.

Obviously, significant odds of planetary devastation is a catastrophic risk, so obviously insurance against this is not just low risk, it's negative risk, so the required rate of return should be far lower than the required rate of return for a diversified stock portfolio. It should, in fact, be negative. With such an appropriate required rate of return, any credible model clearly shows we should be spending far more on anti global warming measures – and right now.

I made this point in my blog action day post last October, but it's not being made nearly enough. This should be said vociferously every time someone says we should use the market discount rate, or anything close to it, for global warming insurance.

Let me be clear here: What is the required rate of return used by William Nordhaus, the most prominent proponent of the ramp, with the most prominent model, the DICE model?

The approach in the DICE model is to use the estimated market return on capital as the discount rate. The estimated discount rate in the model averages 4 percent [real, inflation adjusted] per year over the next century. (page 19)
So his model then says we should spend relatively lightly on global warming at this time (relative, that is, to a model like Nicholas Stern's of the London School of Economics). But imagine how much his model would say we should spend if we used a negative rate of return like that accepted by almost everyone for car and homeowners insurance. The planet is, of course, our home, and the home of our children, our grandchildren, and their grandchildren.

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