Abstract
U.S. environmental regulations are increasingly influenced by cost-benefit analyses that are performed based on the guidance of the Office of Management and Budget (OMB). The OMB’s Circular A-4 directs Federal agencies to assume “risk neutrality” in conducting regulatory analysis, and in important instances, this guidance is not supported by economic theory. Risk neutrality is computationally convenient, and it can be justified when only the costs and benefits of regulations themselves are uncertain, because these risks are spread across a large population. However, the Circular A-4 does not distinguish between regulations that cause uncertainty and those that reduce pre-existing (i.e. baseline) uncertainty, such as the potential for catastrophic climate change. Basic economic theory shows that risk aversion should be incorporated into evaluations of policies that reduce pre-existing environmental uncertainty. Regulatory analyses generally ignore these risk-reduction benefits, leading to misinformed policymaking. Quantifying risk premiums is difficult and controversial, but no more so than discounting future costs and benefits to present value terms. Similar to how OMB has established discount rates for use in regulatory analyses, a method for when and how to incorporate risk aversion into policy evaluations should replace the blanket guidance for risk neutrality.
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Notes
Executive Orders 12866 (signed September 1993) and 13563 (signed January 2011) direct government agencies to assess all costs and benefits of available regulatory alternatives and, if regulation is necessary, to select regulatory approaches that maximize net benefits. The Circular A-4 is a document that provides “best practices” guidance to Federal agencies on the development of regulatory analysis and aims to standardize the way benefits and costs of Federal regulatory actions are measured and reported (www.whitehouse.gov).
Note that risk aversion does affect the discount rate, which determines the relative value of costs and benefits over time, but this issue is separate from how uncertainty directly affects the valuation of costs and benefits in any static timeframe, which is the topic of this essay.
The risk aversion of individuals has been shown in the empirical literature (see Meyer and Meyer 2005) and by the existence of an insurance industry that profits from individuals’ willingness to pay premiums (i.e. accept lower expected values) to avoid uncertain outcomes. Economists therefore use concave social welfare functions when evaluating benefits and costs.
Note that accounting for risk aversion in this context is distinct from the influence of risk aversion on the discount rate. It is also distinct from the risks associated with the costs and benefits of the policy itself; instead, it is pre-existing environmental uncertainty that is being reduced by this hypothetical policy.
The Green Book is the United Kingdom’s official guidance for conducting proper regulatory impact analysis, similar to the OMB Circular A-4 in the U.S. While the Green Book appropriately notes that risk-averse decision-makers are willing to pay for certainty (referred to as “the cost of variability”), the formula provided for estimating this cost of variability addresses only the uncertain costs and benefits of the policy itself:
Fraction of income worth paying for certainty = − (Variance of net additional income resulting from the project)/(2 x Total expected income of those impacted by the project).
The Green Book concludes the following: “Given the size of national income relative to the scale of most individual projects, the cost of variability for projects that benefit the community as a whole is usually negligible.” No supplemental guidance is provided on how to estimate benefits for a regulation that reduces baseline uncertainty (see HM Treasury 2011, pp. 88–89).
The literature has also noted many instances when this result of Arrow and Lind (1970) does not hold. In particular, Fisher (1973) shows that environmental externalities or irreversible outcomes provide a basis for the inclusions of risk premiums in the evaluations of risky public investments.
A revised version of this report was published in 2013, but the methodology of the U.S. Government’s Interagency Group on the Social Cost of Carbon was left unchanged from the 2010 report. Only the underlying models from the literature were updated.
For example, in the case of the constant elasticity of substitution (CES) utility function, King et al. (1990) shows that as long as preferences are time separable and geometrically discounted, a representative agent must display a constant elasticity of intertemporal substitution for a balanced growth path to exist. In the context of economic analyses of climate change policies, various papers (e.g. Weitzman 2009; Pindyck 2013) have noted the lack of justification for the chosen functional forms of the social welfare functions.
Halek and Eisenhauer (2001) summarized the state of the literature (a characterization which remains accurate today): “There is little consensus and few generalizations to be drawn from the existing literature regarding the magnitude of relative risk aversion, its behavior with respect to wealth, or its differences across demographic groups.” In addition, laboratory experiments on risk tend to focus on small gambles, but individuals are far more risk averse when faced with potentially catastrophic events (see Ogaki 2001, Bantwal and Kunreuther 2000). Finally, Rabin (2000) shows that within the expected utility theory framework, the welfare functions typically used by economics are incapability of displaying reasonable risk preferences with respect to both small and large risks.
A similar debate exists in the economic literature over the appropriate discount rate to use in welfare analyses that affect multiple generations. Proponents of a “revealed preferences” approach support the use of empirical data on individual preferences to select the appropriate discount rate. In contrast, proponents of a “normative approach” generally support the use of lower discounts rates that implicitly value all future generation equally (for an overview, see Interagency Working Group on Social Cost of Carbon 2010).
In other words, neither risk neutrality (i.e. the assumption of no risk aversion) nor a 0 % annual discount rate (i.e. the assumption that benefits in all time periods should be valued equally) would properly reflect individual preferences.
The danger of this approach is that “supplemental qualitative discussions” to a quantitative analysis are often disregarded in practice. For example, the U.S. Government’s report on the social cost of carbon (2010) includes numerous qualitative statements implying that it may not be providing unbiased estimates, and yet the report’s quantitative estimates of the social costs of carbon are used by other agencies in policy evaluations and discussed by the public as the bottom-line results of the analysis.
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Kaufman, N. Why is risk aversion unaccounted for in environmental policy evaluations?. Climatic Change 125, 127–135 (2014). https://doi.org/10.1007/s10584-014-1146-8
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DOI: https://doi.org/10.1007/s10584-014-1146-8