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2.5.4. The Cost of Uncertainty
This section reviews the primary methods for incorporating uncertainty into
analyses of climate impacts. Here we look at how to judge the cost associated
with uncertainty. Cost and valuation depend, in general, on the entire distribution
of the range of outcomes.
2.5.4.1. Insurance and the Cost of Uncertainty
Risk-averse individuals who face uncertainty try to buy insurance to protect
themselves from the associated risk (e.g., different incomes next year or over
the distant future, depending on the state of nature that actually occurs).
How much? Assuming the availability of "actuarially fair" coverage
(i.e., coverage available from an insurance provider for which the expected
cost of claims over a specified period of time equals the expected income from
selling coverage), individuals try to insure themselves fully so that the uncertainty
would be eliminated. How? By purchasing an amount of insurance that is equal
to the difference between the expected monetary value of all possible outcomes
and the certainty-equivalent outcome that insurance would guarantee—the
income for which utility equals the expected utility of all possible outcomes.
For a risk-averse person, the certainty-equivalent income is less than the
expected income, so the difference can be regarded as WTP to avoid risk. In
a real sense, therefore, willingly paid insurance premiums represent a measure
of the cost of uncertainty. Therefore, they can represent society's WTP
for the assurance that nondiversifiable uncertainty would disappear (if that
were possible). Thus, this is a precise, utility-based measure of economic cost.
The cost of uncertainty would be zero if the objective utility function were
risk-neutral; indeed, the WTP to avoid risk is positive only if the marginal
utility of economic activity declines as income increases. Moreover, different
agents could approach the same uncertain circumstance with different subjective
views of the relative likelihoods of each outcome and/or different utility functions.
The amount of insurance that they would be willing to purchase would be different
in either case. Application of this approach to society therefore must be interpreted
as the result of contemplating risk from the perspective of a representative
individual. Yohe et al. (2000), for example, apply these structures to
and offer interpretations for the distributional international impact of Kyoto-style
climate policy.
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