The Rising Cost of Climate Change: Evidence from the Bond Market

Bauer, Michael D.; Rudebusch, Glenn D.

doi:10.1162/rest_a_01109

Cited by 24 publications

(6 citation statements)

References 64 publications

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“…Finance academics participating in a recent survey have identified discount as a key topic to reduce climate risks [43]. With this paper, we have taken a multidisciplinary perspective from complex systems science and its related methods to study historical bond prices [44], with the aim to contribute to the need of new approaches to evaluate climate action urgency [45,46].…”

Section: Discussionmentioning

confidence: 99%

Discounting the Distant Future: What Do Historical Bond Prices Imply about the Long-Term Discount Rate?

Farmer,

Geanakoplos,

Richiardi

et al. 2024

Mathematics

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We present a thorough empirical study on real interest rates by also including risk aversion through the introduction of the market price of risk. From the viewpoint of complex systems science and its multidisciplinary approach, we use the theory of bond pricing to study the long-term discount rate to estimate the rate when taking historical US and UK data, and to further contribute to the discussion about the urgency of climate action in the context of environmental economics and stochastic methods. Century-long historical records of 3-month bonds, 10-year bonds, and inflation allow us to estimate real interest rates for the UK and the US. Real interest rates are negative about a third of the time and the real yield curves are inverted more than a third of the time, sometimes by substantial amounts. This rules out most of the standard bond-pricing models, which are designed for nominal rates that are assumed to be positive. We, therefore, use the Ornstein–Uhlenbeck model, which allows negative rates and gives a good match to inversions of the yield curve. We derive the discount function using the method of Fourier transforms and fit it to the historical data. The estimated long-term discount rate is 1.7% for the UK and 2.2% for the US. The value of 1.4% used by Stern is less than a standard deviation from our estimated long-run return rate for the UK, and less than two standard deviations of the estimated value for the US. All of this once more reinforces the need for immediate and substantial spending to combat climate change.

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Section: Discussionmentioning

confidence: 99%

Discounting the Distant Future: What Do Historical Bond Prices Imply about the Long-Term Discount Rate?

Farmer,

Geanakoplos,

Richiardi

et al. 2024

Mathematics

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“…For discount rates, we downloaded and ran code from a repository(133) that calibrates and simulates discount rates from the random discounting model in Newell and Pizer (134) in a Bayesian framework over a 100 year period. We followed previous guidance and imposed a non-negativity constraint for projected discount rates (135,136). Each house's ensemble member with the same index was given the same draw from the house lifetime distribution.…”

Section: Economic Damages To Structuresmentioning

confidence: 99%

Funding rules that promote equity in climate adaptation outcomes

Pollack,

Santamaria-Aguilar,

Maduwantha

et al. 2024

Preprint

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Many climate policies adopt improving equity as a key objective. Achieving this broad goal is non-trivial. A key challenge is that policies often conceive of equity in terms of individuals but introduce strategies that focus on spatially coarse administrative areas like census tracts. For example, the Justice40 Initiative in the United States requires 515 diverse federal programs to prioritize funds for “disadvantaged” census tracts. This strategy is largely untested and contrasts with the federal government’s definition of equity as the “consistent and systematic fair, just and impartial treatment of all individuals.” How well does the Justice40 approach improve equity in climate adaptation outcomes across individuals? We analyze this question using a case study of a municipality that faces repetitive flooding and struggles to effectively manage these risks due to limited resources and public investment. We find that Justice40 is an obstacle to equity. In contrast, we design simple funding based on household risk burden that cost-effectively perform well on a wide range of equity and economic objectives. “Disadvantaged community” indicators defined at coarse spatial scales face the risk of poorly capturing many natural hazards and can be ineffective for meeting equity promises about climate-related investments.

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“…This provides a rational for the demand for 3 Also, the descriptive approach encountered difficulties when considering long horizons, in particular with its inability to provide low and declining risk-free rate levels close to the consensus (Arrow et al 2013, Drupp et al 2018. However, recent work on empirical interest rate models tends to show that the gap has been clearly reduced with the steady decline in real interest rates, once uncertainty has been taken into account correctly (Bauer & Rudebusch 2021;Newell, Pizer & Prest 2022;Rennert et al 2022b). This led the US Environmental Protection Agency to propose new risk-free discount rate paths using the Ramsey formula calibrated on those latest empirical evidence (EPA 2021).…”

Section: Normative Asset Pricingmentioning

confidence: 99%

Fixing Our Public Discounting Systems

Cherbonnier

Gollier

2023

Annu. Rev. Financ. Econ.

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Most Western countries use a single discount rate to evaluate public investments and policies. This ignores the cost of risk, in a world where most risk markets exhibit surprisingly large prices of risk. The current discounting guidelines generate a misallocation of capital that entails a large welfare cost. We claim that the well-established asset pricing literature provides a strong normative justification in favor of risk-adjusting discount rates. More specifically, project-specific discount rates should be increasing in the income elasticity of the project's net benefit. This will favor projects whose net benefit materializes preferentially in low-income states, thereby recognizing their insurance benefit ex ante. The intuition is simple, the welfare benefit of the reform is large, and the methodology only requires evaluators to estimate an income elasticity on top of what is required in the current approach. It is time to fix our public discounting systems. Expected final online publication date for the Annual Review of Financial Economics, Volume 15 is November 2023. Please see http://www.annualreviews.org/page/journal/pubdates for revised estimates.

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The Rising Cost of Climate Change: Evidence from the Bond Market

Cited by 24 publications

References 64 publications

Discounting the Distant Future: What Do Historical Bond Prices Imply about the Long-Term Discount Rate?

Discounting the Distant Future: What Do Historical Bond Prices Imply about the Long-Term Discount Rate?

Funding rules that promote equity in climate adaptation outcomes

Fixing Our Public Discounting Systems

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