Environmental Protection, Rare Disasters and Discount Rates

The Stern Review 's evaluation of environmental protection stresses low discount rates and uncertainty about environmental effects. An appropriate model for analysing this uncertainty and the associated discount rates requires sufficient risk aversion and fat‐tailed uncertainty to account for the observed equity premium. Calibrations based on Epstein–Zin preferences and existing analyses of rare macroeconomic disasters suggest that optimal environmental investment can be a significant share of GDP even with reasonable rates of time preference. Optimal environmental investment increases with risk aversion and the probability and typical size of environmental disasters, but decreases with uncertainty about policy effectiveness.