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Why is risk aversion unaccounted for in environmental policy evaluations?

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  • Noah Kaufman

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. Copyright Springer Science+Business Media Dordrecht 2014

Suggested Citation

  • Noah Kaufman, 2014. "Why is risk aversion unaccounted for in environmental policy evaluations?," Climatic Change, Springer, vol. 125(2), pages 127-135, July.
  • Handle: RePEc:spr:climat:v:125:y:2014:i:2:p:127-135
    DOI: 10.1007/s10584-014-1146-8
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    References listed on IDEAS

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    1. van den Bergh, J.C.J.M. & Botzen, W.J.W., 2015. "Monetary valuation of the social cost of CO2 emissions: A critical survey," Ecological Economics, Elsevier, vol. 114(C), pages 33-46.
    2. Rohrig, Maren B.K. & Hardeweg, Bernd & Lentz, Wolfgang, 2018. "Efficient farming options for German apple growers under risk – a stochastic dominance approach," International Food and Agribusiness Management Review, International Food and Agribusiness Management Association, vol. 21(1).
    3. Taylan G. Topcu & Konstantinos Triantis, 2022. "An ex-ante DEA method for representing contextual uncertainties and stakeholder risk preferences," Annals of Operations Research, Springer, vol. 309(1), pages 395-423, February.
    4. Jeddi, Samir & Lencz, Dominic & Wildgrube, Theresa, 2021. "Complementing carbon prices with Carbon Contracts for Difference in the presence of risk - When is it beneficial and when not?," EWI Working Papers 2021-9, Energiewirtschaftliches Institut an der Universitaet zu Koeln (EWI), revised 16 Aug 2022.

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