How Costly is Global Warming? Implications for Welfare, Business Cycles, and Asset Prices. M. Donadelli M. Jüppner M. Riedel C.

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1 How Costly is Global Warming? Implications for Welfare, Business Cycles, and Asset Prices. M. Donadelli M. Jüppner M. Riedel C. Schlag Goethe University Frankfurt and Research Center SAFE BoE-CEP workshop: Central Banking, Climate Change and Environmental Sustainability

2 Goal Quantify the short- and long-run effects of global warming on asset prices and productivity To do so, we build a production economy along the lines of Croce (214, JME) featuring: - long run-temperature risk as in Bansal and Ochoa (211, NBER) - recursive preferences - long-run productivity risk - investment adjustment costs - sticky wages

3 Background and motivation Popular approach: - Integrated assessment models (IAMs): integrate climate change with standard economic modeling - Stern Review (27), Nordhaus (21, PNAS) and Nordhaus (214, Journal of the Association of Environmental and Resource Economists) Pindyck (213,JEL): IAMs have crucial flaws that make them close to useless as tools for policy analysis : - certain inputs (e.g., the discount rate) are arbitrary, but have huge effects on models output - IAMs can be thus used to obtain almost any result one desires. - models descriptions of the impact of climate change are completely ad hoc, with no theoretical or empirical foundation - no theoretical support on the shape of the loss functions (e.g., T=3 C or T=7 C Ñ no diff) - some effects of warming may be permanent Ñ a growth rate effect allows warming to have a permanent impact

4 Background and motivation Moreover... - Revesz et al. (214, Nature) point out that current models omit adverse effects on labor productivity, productivity growth and the value of capital stock - Empirical literature suggests effects of global warming on growth rates (Dell et al. (212, AEJ); Bansal and Ochoa (211, NBER) and Colacito et al. (216, UNC WP)) - Weitzman (27, JEL) and Nordhaus (27, JEL) criticize that the model of Stern is not consistent with financial market facts - Remark: data exhibit small fluctuations in temperature and other whether variables (i.e., we cannot study the effect of a 5 C Ò). We cannot thus specify and calibrate damage functions of the sort used in IAMs

5 Temperature Anomalies Figure: Global Temperature Anomalies. Source: NASA Panel A: 1925 Panel B: 195 Panel C: 197 Panel D: 1985 Panel E: 2 Panel F: 215

6 Temperature Anomalies Figure: Global Temperature Anomaly Index (19-215). Source: NASA

7 Global Warming and Aggregate Productivity Figure: Global Temperature, Rainfall and Productivity Panel A: Panel b: Response of TFP Growth to a Global Temperature Shock Response of TFP Growth to a Shock in Rainfall % % Years Years

8 Global Warming (???) Do people care? Apparently, yes!!! First of all, it s still at the center of the policy debate From the Democrat and Republican presidential front-runners: Hillary Clinton: Ñ Hillary will:... national plan to get 5 million solar panels installed... bring greenhouse gas emissions to 3 percent below the 25 level... and other hundreds things to fight against climate change... (See Donald Trump: He isn t a believer that humans have played a significant role in the Earth s changing climate (The Washington Post, March 216) News from last summer, The 3 amigos met in Ottawa and announced the North American Climate, Clean Energy and Environment Partnership

9 Households The representative household is equipped with recursive preferences: U t p1 βq C {ψ ψ t β Et ru 1 γ 1 t 1 s 1 γ 1 1{ψ, where C t is a Cobb-Douglas aggregator for consumption and leisure: C t : C pc t, L t q C ν t pa t p1 L t qq 1 ν. In each period, the representative household chooses consumption C t and labor L t to maximize (1) subject to the following budget constraint C t B t 1 ϑ t 1 pv t D t q W u t L t B t R f t ϑ tv t. where ϑ t denotes equity shares in the firm held from time t 1 to time t, V t is the cum-dividend market value of the production sector, D t represents the production sector s dividends, B t denotes bond holdings from time t 1 to time t, Rt f is the gross risk-free rate, and Wt u represents the frictionless wage.

10 Firms The production sector admits a representative perfectly competitive firm utilizing capital and labor to produce the final good. The production technology is given by: Y t K α t pa tl t q 1 α, where α is the capital share, labor L t is supplied by the household, and A t is the exogenous labor-augmenting productivity. The capital stock evolves according to: It K t 1 p1 δ K qk t G K t, K t where δ K is the depreciation rate of capital. G t is a function transforming investment into new capital which entails convex adjustment costs of investments as in Jermann (1998): It G t : G α 1 It 1 1 τ K t 1 1 K τ t α 2.

11 Firms Firms choose capital, labor and investment to maximize their value: Firms optimal decisions lead to: V max L t,i t,k t q t 8 E M,t D t, 1 t 1 G 1 I t K t. where q t defines the marginal value of standardized capital which is equal to the marginal rate of transformation between new capital and consumption. The firm chooses capital such that: 1 αyt 1 E 1 I t 1 t M t,t 1 q t 1 pg t 1 1 δ K q. q t K t 1

12 Firms EE: 1 E t M t,t 1 R t 1, where and R t 1 d t 1 q t 1 q t, d t 1 α Y t 1 K t 1 I t 1 K t 1 q t 1 G t 1 δ K q t 1

13 Labor Market We assume that labor supply is subject to frictions. In the spirit of Uhlig (27), we impose that a fraction of the labor supply does not reach the market. This results in sticky wages: W t pe µa W t 1 q ξ pw u t q 1 ξ.

14 Productivity and Temperature Dynamics The productivity growth rate, a t 1 logpa t 1 {A t q, has a long-run risk component, x t, and evolves according to where Temperature dynamics are given by a t 1 µ a x t σ a ɛ a,t 1, x t 1 ρ x x t τ z σ ζ ζ t 1 σ x ɛ x,t 1. z t 1 µ z ρ z pz t µ z q σ ζ ζ t 1. - Temperature shocks ζ t indicate long-run shocks which affect the stochastic component in expected productivity growth x t. - The parameter τ z captures the impact of temperature shocks on long-run productivity growth. - We assume that productivity does not affect temperature in turn.

15 Resource Constraint Y t C t I t

16 Benchmark calibration Preferences β Subjective time discount factor.999 ψ Elasticity of intertemporal substitution 1.85 γ Relative risk aversion 7.5 ν Consumption share in utility bundle.3484 Labor Market ξ Wage rigidity parameter.35 Production and Investment Parameters α Capital share in final good production.345 δ K Depreciation rate of physical capital.5 τ Capital adjustment costs elasticity.7 TFP µ a Long-run mean of TFP.4 σ a Volatility of short-run shocks to TFP.8 ρ x Long-run TFP shock persistence.982 σ x Volatility of long-run shocks to TFP.45*σ a Global Temperature µ z Long-run mean of global temperature τ z Impact of temperature innovations on TFP growth.25 ρ z Temperature persistence parameter.99 σ z Volatility of shocks to global temperature.41

17 Benchmark calibration Figure: Model-Implied Response of Productivity to a Temperature Shock % Deviation from Steady State Benchmark Calibration Higher Temperature Effects Years

18 Quantitative results: Macro Quantities Variable Data Benchmark τ z CRRA τ z.45 calibration [1] [2] [3] [4] MACRO QUANTITIES Er as σp lq σp cq{σp yq σp iq{σp yq σp lq{σp yq ρp c, yq ρp c, iq ρp i, lq

19 Quantitative results: Temp and Asset Prices Variable Data Benchmark τ z CRRA τ z.45 calibration [1] [2] [3] [4] TEMPERATURE Erzs σpzq ρp z, aq ρp z 5Y, a 5Y q ρp z 1Y, a 1Y q ρp z, yq ρp z 5Y, y 5Y q ρp z 1Y, y 1Y q ASSET PRICES ErR f s σpr f q ErR m R f s σperr m R f sq

20 Transmission of a Temperature Shock I (σ ζ ) Panel A: c t Panel B: i t Panel C: y t Panel D: l t Panel E: (y/l) t Panel F: M t,t

21 Transmission of a Temperature Shock II (σ ζ ) Panel A: E t [ c t+1 ] Panel B: E t [ i t+1 ] Panel C: E t [ y t+1 ] 5 5 x 1 3 Panel D: E t [ l t+1 ] Panel E: E t [ (y/l) t+1 ]

22 Welfare costs In the spirit of Lucas (1987), Bansal and Ochoa (211), Croce(213) and Evers (215) costs are computed by comparing the utility of an agent living in an economy with temperature risk to the utility of an agent living in a economy without temperature risk: where ErU pp1 q Cqs ErU p C qs, C t C t u 8 t denotes the consumption path with temperature risk C t C t u 8 t is the consumption path without temperature effects.

23 Welfare costs Temperature risk generates non-negligible welfare costs: Table: Temperature Risk vs. Macroeconomic Risk: A Welfare Analysis IES (ψ) Benchmark τ z.45 Short-run Long-run calibration macro risk macro risk [1] [2] [3] [4].9 9% 32% 21% 185% % 44% 27% 299% - composite consumption of the agent living in the economy with temperature effects: p12%q Ò - this brings him/her to the utility level of an agent living in an economy without temperature risk

24 Welfare costs Welfare costs of temp risk in the endowment economy of Bansal and Ochoa (211) are around 1% - welfare costs produced by the volatility in productivity are amplified in economies with capital adjustment costs (Barlevy, 24) - welfare costs in a production economy are higher than those observed in an endowment economy (Croce, 26) - ñ most of the difference in welfare costs can be attributed to effects actually coming from the real side of the economy (i.e. investment)

25 Welfare costs Figure: Welfare Costs 15 1 % τ z x 1 3

26 Long-Term Effects of Global Warming Table: The Long-run Effect of a Global Temperature Shock N Panel A: j1 y t j N y Difference in expected output growth after a shock to global temperature Shock size 1Y 5Y 1Y 2Y 5Y 1 std. dev. σ z std. dev. σ z N Panel B: j1 lp t j N lp Difference in expected labor productivity growth after a shock to global temperature Shock size 1Y 5Y 1Y 2Y 5Y 1 std. dev. σ z std. dev. σ z

27 Concluding Remarks We find that Global warming - decreases asset valuations and increases risk premium - reduces long-run growth perspectives for output and labor productivity - produces sizable welfare costs Possible extensions: - Climate change in a stochastic endogenous growth model - Fiscal policy and global warming adverse effects - Include social factors of global warming (social unrest etc.) - Feedback between technology and temperature dynamics