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IED Working Paper 14

Irreversibility and Optimal Timing of Climate Policy

Justin Caron and Markus Ohndorf

The authors focus on the optimal timing of climate change mitigation policies, a decision which is complicated by multiple sources of irreversibility or inertia. The pertinence of Real Option Theory in understanding the optimal amount of necessary precautionary behavior is explored, as are the results from modeling exercises. Generally, it appears that irreversibility associated with sunk abatement capital is stronger than that from accumulating greenhouse gas emissions, implying an "option value" to delaying climate change mitigation. The inclusion of tipping points, or non-linearities in environmental damages, could nevertheless lead to the opposite conclusion. These effects are however not easily quantifiable and are not generally included in modeling exercises. The timing decision will therefore have to be made by policy makers after having subjectively evaluated the importance of potential tipping points. It is for this reason that policy-makers need to be able to themselves understand the intuition behind Real Option theory - the interplay between irreversibility and uncertainty. Many climate-economic modeling exercises have implicitly recognized this fact by integrating strict environmental targets which serve as hard constraints and represent precautionary behavior.

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IED Working Paper 15

On Adaptation to Climate Change and Risk Exposure in the Nile Basin of Ethiopia

Salvatore Di Falco and Marcella Veronesi

The study investigates the impact of climate change adaptation on farm households’ downside risk exposure (e.g., risk of crop failure) in the Nile Basin of Ethiopia. The analysis relies on a moment-based specification of the stochastic production function. We estimate a simultaneous equations model with endogenous switching to account for the heterogeneity in the decision to adapt or not, and for unobservable characteristics of farmers and their farm. We find that (i) climate change adaptation reduces downside risk exposure; farm households that implemented climate change adaptation strategies get benefits in terms of a decrease in the risk of crop failure; (ii) farm households that did not adapt would benefit the most in terms of reduction in downside risk exposure from adaptation; and (iii) there are significant differences in downside risk exposure between farm households that did and those that did not adapt to climate change. The analysis also shows that the quasi-option value, that is the value of waiting to gather more information, plays a significant role in farm households’ decision on whether to adapt to climate change. Farmers that are better informed may value less the option to wait to adapt, and so are more likely to adapt than other farmers.

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