What Financial Markets Can Teach Us About Managing Climate Risks

Michael Greenstone: “Last week, President Trump signed an executive order about climate change that runs counter to this insight from financial markets. The headlines rightly highlighted the dismantling of climate policies like the Clean Power Plan. But buried in the details is an administrative tweak to the most important climate measurement in the federal government’s climate toolbox: the social cost of carbon.”

“Before the executive order, the social cost of carbon was set at about $40 per metric ton of carbon released. Under the executive order, President Trump appears to be putting us on a path toward valuing climate damages at much less — possibly less than $5 per metric ton of carbon.”

“A concept known as the discount rate makes it possible to translate future damages into their present value… When discounting future costs, the markets tell us to choose a discount rate that matches the risk profile of the investment. So if the risk acts like a tax on the economy (e.g., it reduces G.D.P. by a fixed percentage), a higher discount rate like the stock market’s average annual return of 5 percent would be justified. But if the risk is potentially disruptive, like a severe recession or worse, then markets point to a lower discount rate, perhaps like gold’s annual average return or even lower… In this way, financial markets tell us that spending a little extra now as insurance to protect against potentially disruptive risk is a wise strategy. This lesson was most recently illustrated during the Great Recession.”

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