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This article appears in the following Oxford Review of Economic Policy issue: CLIMATE CHANGE [View the issue table of contents]
The behavioural economics of climate change
* University of Oslo, e-mail: k.a.brekke{at}econ.uio.no
** School of Business, Economics and Law, University of Gothenburg, e-mail: olof.johansson{at}economics.gu.se
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This paper attempts to bring some central insights from behavioural economics into the economics of climate change. In particular, it discusses (i) implications of prospect theory, the equity premium puzzle, and time-inconsistent preferences in the choice of discount rate used in climate-change cost assessments, and (ii) the implications of various kinds of social preferences for the outcome of climate negotiations. Several reasons are presented for why it appears advisable to choose a substantially lower social discount rate than the average return on investments. It also seems likely that taking social preferences into account increases the possibilities of obtaining international agreements, compared to the standard model. However, there are also effects going in the opposite direction, and the importance of sanctions is emphasized.
Key Words: behavioural economics • prospect theory • equity premium puzzle • social preferences • climate negotiations
We are grateful for useful comments from Cameron Hepburn, David Hendry, Steffen Kallbekken, Åsa Löfgren, Snorre Kverndokk, Thomas Sterner, Asbjorn Aaheim, Olle Häggström, Tobias Schmidt, an anonymous referee, and participants at a seminar arranged by the Oxford Review of Economic Policy in Oxford. We also gratefully acknowledge financial support from the Swedish International Development Cooperation Agency (Sida).
1 In Merha and Prescott's (2003) survey, the highest risk-free rate is 3.2 per cent for Germany, 1978–97, and the lowest equity premium is 3.3 per cent for Japan, 1970–99. Dimson et al. (2007) argue that the premium tends to be overestimated, but that the puzzle nevertheless remains.
2 We do not suggest that all other explanations are wrong. Indeed, we consider it likely that several contribute to our understanding, albeit to different extents.
3 This formulation disregards two important elements of prospect theory. First, people are assumed to be risk-averse for gains and risk-seeking for losses. With the calibrated version used in Benartzi and Thaler (1995), these effects are weak. Second, people are assumed effectively to overestimate low probabilities and underestimate large ones. This is disregarded in Benartzi and Thaler's analysis.
4 Recent alternative (partial or complete) explanations of the equity premium puzzle include: disasters with non-negligible probabilities (Barro, 2006), which is somewhat similar to the explanation by Weitzman (2007a) mentioned above; transaction costs (Jang et al., 2007); habit formation (Pijoan-Mas, 2007); and incomplete risk sharing among stockholders resulting from the combination of aggregate uncertainty, borrowing constraints, and idiosyncratic shocks (Gomes and Michaelides, 2008).
5 Actually, the PT predicts that individuals are risk-seeking when it comes to losses. Hence the predicted required rate of return should be slightly higher than the risk-free rate, since we should like to increase risk when risk-seeking. The claimed convexity is, however, very weak and the effect should be very small.
6 Including the pure time preference of Stern, 
, one billion today corresponds to four billion 100 years from now.
7 However, as pointed out by Dietz and Stern (2008), most cost–benefit analyses do not use welfare weights at all, corresponding to 
= 0.
8 Based on the GDP per capita of $27,700 from OECD (2005), together with the conservative assumption that consumption constitutes 60 per cent of GDP.
9 We do not suggest that it is necessarily advisable to lump both aspects of distribution into one single parameter. Sensitivity analysis in Stern (2007) also finds that the present value can be non-monotonic in 
.
10 One straightforward way of incorporating an adequate compensation mechanism would be to introduce a global system of tradable permits, where the initial allocation is proportional to the population size in each country. Or, with a very similar distributional implication, impose a global tax on the emission, where the revenues are distributed back in proportion to population size. Furthermore, one may argue that poorer countries should have the right to emit more than the richer countries in the future, in order to compensate for their lower emissions in the past. However, that this appears ethically reasonable (e.g. Kverndokk, 1995) does not, of course, imply that it is politically feasible.
11 The fifth, and the one that killed off the dinosaurs, was according to the same source largely due to a meteor impact. We are grateful to David Hendry for directing us to this research.
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