Intergenerational Equity in Models of Climate Change Mitigation: Stochastic Interest Rates introduce Adverse Effects, but (Non-linear) Funding Costs can Improve Intergenerational Equity

Abstract

Assessing the costs of climate change is essential to finding efficient pathways for the transition to a net-zero emissions economy, which is necessary to stabilise global temperatures at any level. In evaluating the benefits and costs of climate change mitigation, the discount rate converting future damages and costs into net-present values influences the timing of mitigation. Here, we amend the DICE model with a stochastic interest rate model to consider the uncertainty of discount rates in the future. Since abatement reduces future damages, changing interest rates renders abatement investments more or less beneficial. Stochastic interest rates will hence lead to a stochastic abatement strategy. We introduce a simple stochastic abatement model and show that this can increase intergenerational inequality concerning cost and risk. Analysing the sensitivities of the model calibration analytically and numerically exhibits that intergenerational inequality is a consequence of the DICE model calibration (and maybe that of IAMs in general). We then show that introducing funding of abatement costs reduces the variation of future cash-flows, which occur at different times but are off-setting in their net-present value. This effect can be interpreted as improving intergenerational effort sharing, which might be neglected in classical optimisation. This mechanism is amplified, including dependence of the interest rate risk on the amount of debt to be financed, i.e. considering the limited capacity of funding sources. As an alternative policy optimisation method, we propose limiting the total cost of damages and abatement below a fixed level relative to GDP - this modification induces equality between generations compared to their respective economic welfare, inducing early and fast mitigation of climate change to keep the total cost of climate change below 3% of global GDP.