Environment, Uncertainty, and Option Values

Abstract

"It is trivial to note that the future is uncertain. It is, however, far from trivial to analyze that uncertainty. The environmental field, in particular, is permeated by uncertainty. Besides the usual economic uncertainties, we have major uncertainties characterizing our knowledge of environmental processes. Often, we simply do not know the long run consequences of interventions in the environment. For example, for many new chemicals, we do not know whether they are carcinogenic or not. Our models of ecosystems dynamics are far from precise. Moreover, future preferences for environmental services are uncertain, which means that future benefits from nature preservation today are uncertain. These topics will be addressed in this chapter. In the next section, we will look at an essentially static framework to look at the role of risk aversion in valuing uncertain environmental benefits. The main tool is the use of quadratic approximations of the von Neuman - Morgenstern utility functions, and the main result is that the benefits from environmental policy reforms depend on risk aversion as measured by the Arrow-Pratt measure of absolute risk aversion and on the variance and covariance of the distributions of preferences and the supply of environmental quality and the wealth (or income) of the individuals. When aggregating the benefits over the whole population of households in the economy, some risks will be highly correlated and it is therefore impossible to bring down the cost of risk bearing by pooling risks. On the other hand, it will of course be possible to reduce the cost of risk bearing by diversification (something which is not studied in this chapter). The key issue of whether the difference between total and expected benefits (called option value in the earlier literature) is positive or negative can be much better understood from the point of view of the covariances between environmental uncertainty and preference uncertainty."