Welfare Costs of Long-Run Temperature Shifts

Working Paper: NBER ID: w17574

Authors: Ravi Bansal; Marcelo Ochoa

Abstract: This article makes a contribution towards understanding the impact of temperature fluctuations on the economy and financial markets. We present a long-run risks model with temperature related natural disasters. The model simultaneously matches observed temperature and consumption growth dynamics, and key features of financial markets data. We use this model to evaluate the role of temperature in determining asset prices, and to compute utility-based welfare costs as well as dollar costs of insuring against temperature fluctuations. We find that the temperature related utility-costs are about 0.78% of consumption, and the total dollar costs of completely insuring against temperature variation are 2.46% of world GDP. If we allow for temperature-triggered natural disasters to impact growth, insuring against temperature variation raise to 5.47% of world GDP. We show that the same features, long-run risks and recursive-preferences, that account for the risk-free rate and the equity premium puzzles also imply that temperature-related economic costs are important. Our model implies that \na rise in global temperature lowers equity valuations and raises risk premiums.

Keywords: Temperature Fluctuations; Economic Costs; Financial Markets; Utility Costs; Asset Pricing

JEL Codes: E0; G0; Q0

Causal Claims

Cause	Effect
Increase in global temperature (Q54)	Lower equity valuations (G19)
Increase in global temperature (Q54)	Higher risk premiums (G19)
Temperature shocks (E32)	Negative impact on long-run growth (F69)
Negative impact on long-run growth (F69)	Impact on wealth-to-consumption ratio (E21)
Temperature-related utility costs (L97)	Lower consumption (E21)
Dollar costs of insuring against temperature variation (G52)	Percentage of world GDP (F62)
Costs rise to 5.47% of world GDP (F62)	Accounting for temperature-triggered natural disasters (Q54)