Sustainable Finance and Climate Risk
Strategic interactions and uncertainty in decisions to curb greenhouse gas emissions
Department of Economics, University of Waterloo,
Department of Economics, Wilfrid Laurier University
Peter A. Forsyth,
David R. Cheriton School of Computer Science, University of Waterloo,
Climate change caused by human activity represents a particularly intractable "tragedy of the commons" which can only be addressed by cooperative actions of key decision makers representing nations or regional governments. The likely success of the cooperative actions is hampered by the large incentives for free-riding by those who are motivated to delay signicant cuts in carbon emissions in hopes that others will do the \heavy lifting". Further complicating the problem are the enormous uncertainties inherent in predicting climate responses to the buildup in atmospheric carbon stocks and resulting impacts on human welfare, including the prospects for adaptation and mitigation. These huge uncertainties and the need for cooperative global action have been used by some as justication for delaying aggressive unilateral policy actions. This research seeks to gain a better understanding of the impact of the strategic interactions of decision-makers on the ability of the world community to make meaningful global reductions in greenhouse gases. We develop an economic model of the optimal decisions of two large emitters of greenhouse gases given uncertainty in future temperature levels. A summary of the model and preliminary results are presented below.
- The global average temperature is modelled as a mean-reverting stochastic process driven by the stock of atmospheric carbon. Emissions of carbon result in short-term economic gains. However, increasing carbon levels result in long-term increasing temperature, which causes damage to the global econom
- We consider two large competing regional economies, which individually choose a level of carbon emissions on a bi-annual basis. We model the choice of emission level as a non-cooperative Stackelberg game, i.e. there is a leader (who chooses the emission level rst) and a follower. Damages are modelled as a function of temperature. We consider cases when damage functions of the two players are identical as well as cases where one player experiences greater damages from rising temperature.
- We compare the results of the non-cooperative game to the choice of a Social Planner who chooses emission levels which maximize the sum of the utilities for the two regions.
- Standard economic models pay insufficient attention to the possible disastrous effects of large temperature changes. We have modified the standard damage functions to address these issues. We nd that the stochastic temperature effects cannot be ignored:
- temperature changes of ±(0.5 - 1.0)°C can occur solely due to volatility, regardless of the current stock of atmospheric carbon.
- Our results indicate that the leader has an advantage compared to the follower, even when both players have identical damage functions.
- The results of the non-cooperative game are in sharp contrast to the results obtained assuming a Social Planner. The Social Planner cuts back on emissions much more aggressively than in the Stackelberg game, thus indicating a classic tragedy of the commons.
- In the case of asymmetric damages, the player with higher damages from rising temperatures is negatively aected by the actions of the other player. While the player with higher damages cuts back on their emissions aggressively, the low damage player takes advantage of this by increasing their own own emissions relative to the symmetric damage function case. In this case, the benets of a cooperative solution (the Social Planner case) are even more important.
- If one player is more environmentally aware, they may receive a psychological benet (a green reward) from reducing carbon emissions. In this case, we observe a form of Green Paradox: if the follower cuts back on emissions, due to more environmentally friendly preferences, the leader takes advantage of this and increases their emissions, thus counteracting the environmentally friendly sentiments of the follower. However, we also observe a contrary effect, which we call the green bandwagon effect. For some high values of the carbon stock, the presence of a green reward for one player causes the less environmentally aware player to reduce its own emissions (relative to the case with no green reward). Our interpretation is that at higher levels of carbon stock, green sentiments in one player can reduce the effect of the tragedy of the commons.