US environmental regulations are increasingly influenced by cost-benefit analyses that are performed based on the guidance of the Office of Management and Budget (OMB). The OMB's Circular A-4 directs Federal agencies to assume "risk neutrality" in conducting regulatory analysis, and in important instances, this guidance is not supported by economic theory. Risk neutrality is computationally convenient, and it can be justified when only the costs and benefits of regulations themselves are uncertain, because these risks are spread across a large population. However, the Circular A-4 does not distinguish between regulations that cause uncertainty and those that reduce pre-existing (i.e. baseline) uncertainty, such as the potential for catastrophic climate change. Basic economic theory shows that risk aversion should be incorporated into evaluations of policies that reduce pre-existing environmental uncertainty. Regulatory analyses generally ignore these risk-reduction benefits, leading to misinformed policymaking. Quantifying risk premiums is difficult and controversial, but no more so than discounting future costs and benefits to present value terms. Similar to how OMB has established discount rates for use in regulatory analyses, a method for when and how to incorporate risk aversion into policy evaluations should replace the blanket guidance for risk neutrality.
In this paper, NERA Senior Consultant Dr. Noah Kaufman examines the benefits of reducing pre-existing uncertainty, explores why risk aversion is unaccounted for in environmental policy evaluations, and provides a way forward.
The final version of this publication appeared in Volume 125, Issue 2, July 2014 edition of Climatic Change, pp 127-135. The final publication is available at http://rd.springer.com/article/10.1007/s10584-014-1146-8.Click here to read this paper.