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Climate change presents the economy with an uncertain future. Policymakers typically want to justify decisions based on a pretense of knowledge, says Lars Peter Hansen, a Nobel laureate and the David Rockefeller Distinguished Service Professor of Economics at the University of Chicago Departments of Economics and Statistics and at Chicago Booth. This can make researchers hesitant to communicate the full uncertainties that emerge from climate-economic research, such as the long-term human impact on climate change, or the ultimate damages to the economy and society. Since these uncertainties are substantial and challenging to quantify, there is a fear that some policymakers will use this as an excuse to delay action.

“In the case of climate change, that delay can make it much costlier to address the consequences of climate change in the future,” Hansen said during the Climate Challenge, the second event in Booth’s Future of Capitalism series. The event was co-sponsored by Booth’s Rustandy Center for Social Sector Innovation.

How can decision theory help better incorporate uncertainty into climate-economics models designed to support policy analysis? More generally, what are productive ways to confront climate change from the vantage point of both policymakers and private sector enterprises?

Hansen explored these questions with Mili Fomicov, ’11, research associate at Imperial College’s Centre for Climate Finance and Investment, and Sir Ronald Cohen, chairman of Impact Investment’s Global Steering Group and The Portland Trust. He’s also the author of IMPACT: Reshaping Capitalism to Drive Real Change (2021). Moderated by Randall S. Kroszner, deputy dean for Executive Programs and the Norman R. Bobins Professor of Economics, their conversation illuminated the trade-offs of climate action, the role of technology, and the importance of financial risk models.

Best Guesses and Possible Bad Outcomes

Decision theory formalizes two important trade-offs pertaining to uncertainty and climate policy, suggests Hansen, whose joint research on pricing uncertainty and climate change recently won the 2021 Review of Financial Studies Michael J. Brennan Best Paper Award. Quantitative models can be used to make best guesses and to explore possible bad outcomes for society. How do we trade off such considerations?

“Imagine you’ve got many dimensions to the uncertainties reflected in a quantitative model,” Hansen said. “The aim of our research is to reduce that down into something very small scale—to say, ‘These are the most troubling ones.’”

While decision theory formalizes trade-offs between best guesses and possible bad outcomes, it is up to decision-makers to decide how averse they are to the latter, Hansen said. This aversion is then reflected in prudent policy making.

The Trade-Off between Waiting and Acting Now

The second trade-off is dynamic in nature, Hansen said. Since we are uncertain about the quantitative magnitude of damages, we could either wait until we witness some of the possibly severe consequences of climate change, or we can act now based on the possibility of such severe consequences—because it is arguably less costly to address climate change now. Down the road there may be good news (consequences are not as dramatic as we feared), or bad news (indeed, some of worst fears are realized). Such a trade-off is absent in many simplistic analyses of climate change uncertainty, Hansen added. Decision theory gives a framework for thinking in such dynamic terms.

“While better data can help us cope with some aspects of uncertainty, data alone is not sufficient,” Hansen said. “The slogan ‘evidence-based policy’ is a common refrain, but to interpret the evidence and use it in policy analyses requires a conceptual framework, a formal model or a set of such models. This is particularly true in the case of climate change as we consider pushing economies into places that have not been experienced with data.”

A More Comprehensive Formulation of Uncertainty

As Hansen argues, there are good reasons to think of climate change using broader notions of uncertainty than is typical in risk assessment models. Model-based risk assessments typically feature uncertain outcomes with known, model-generated probabilities. But to assess exposure to climate change, there is uncertainty as to which model predictions to feature and how to cope with their stylized and simplified nature.

Hansen has used decision theory to work through analyses that account for uncertainty conceptualized in broader terms. For example, the social cost of carbon might be calculated much like an asset in a dividend stream. When emissions go into the atmosphere, there are social consequences that can be calculated immediately and into the future. Much like in investment theory, uncertainty plays a central role in social valuation.

Technology and Transparency

A traditional economic trade-off is risk versus return. Cohen, who is widely considered the father of impact investment, believes that climate change is a key factor in the evolution of that trade-off to risk versus return versus impact.

There’s been a shift in values, Cohen said, with many younger consumers now refusing to purchase from or work with corporations that aren’t climate friendly. This has swayed more investors to funnel billions into environmental, social, and corporate governance trends.

Technology is making climate transparency easier, which Cohen believes will put a greater focus on impact. For example, Cohen points to the Impact-Weighted Accounts Initiative (IWAI), a project he helped launch at Harvard Business School that has examined the climate impact of 3,000 public companies and continues to measure the impacts of companies. The IWAI’s findings suggest that 450 of these companies deliver more environmental damage than they do profit, amounting to $4 trillion worth of environmental damage in a single year.

With this information being so readily transparent and available, impact accounting is now a “foregone conclusion,” Cohen said.

“Within many sectors, you now see a correlation between higher pollution and lower stock market values,” Cohen said. “The weight of ESG money is affecting the valuations of companies. Regulators are, not surprisingly, focusing on impact transparency. The crucial next step is for governments to mandate impact transparency.”

Financial and Climate Risk

At Imperial College London, Fomicov has explored climate uncertainty and the strategic allocation of capital. She’s found that many investors model climate risks by simply stressing certain macro variables. They generally don’t incorporate model uncertainty, which, as Hansen, explained, can go wrong.

Rather than take such a linear approach, climate financial scenarios should provide an interface between transition scenarios and financial risk models, Fomicov said. It may sound daunting, but she notes that investors can import built-in scenarios.

“Investors can choose between different scenarios and select pathways that align with their assessment and their implementation capabilities, for instance, whether they’re long-only or long-short investors, or if they have different liquidity constraints,” Fomicov said. “That is a lot more comprehensive. Investors can build various distributions and simulate different states of the world and incorporate that into their risk model.”

Investors should also further diversify their risks. Investing in carbon allowances, nature-based solutions, or renewable infrastructures in emerging markets, for example, could be great for the climate and investors alike. This is also a great way to achieve climate goals, Fomicov added.

“You’re investing in climate solutions and turning some risks into opportunities and diversifying in this radically uncertain world,” she said.

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