Uncertainty and global warming : an option - pricing approach to policy

How does uncertainty about the extent of global warming affect decision making to reduce it? Which policy options to choose and how long to delay implementing them?

Uncertainty is inherent in the analysis of global warming issues. Not only is there considerable scientific uncertainty about the magnitude of global warming, but even if that problem were resolved, there is uncertainty about what monetary value to assign to the costs and benefits of various policies to reduce global warming.

And yet the influence of uncertainty in policy makers' decisions is ignored in most studies of the issue.

Baranzini, Chesney, and Morisset try to explicitly incorporate the effect of uncertainty on the choice of global warming abatement policies. The approach they develop draws on the emerging literature on investment under uncertainty --- in particular, that on the option valuation approach.

Their numerical applications focus on Cline's (1992) analysis of global warming, but it may be applied to a range of global warming analyses.

First, they assess whether it is optimal to implement Cline's strategy of limiting global warming today, or whether it should be postponed, and for how long.

Then, they identify the optimal policy to be implemented today for different levels of uncertainty about the costs and benefits of policies to reduce global warming.

This paper --- a product of the Country Operations Division, Latin America and the Caribbean, Country Department I --- is part of a larger effort in the region to understand the role of uncertainty in environmental policy issues. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Celinda Dell, room Q7106, extension 85148 (30 pages)