Friday, 29 March 2019: 9:30 AM
Among branches of economics, environmental economics provides an especially rich source of insights into the impact of emotion, cognitive bias, and behavioral heuristics on risk assessment and management. The making of environmental policy is at heart a species of risk management, one where the vectors of physical uncertainty and emotional reaction differ from those of quantitative finance more in degree than in kind.
As a generalized approach to finance, higher-moment asset pricing combines a mathematically informed understanding of economic fundamentals with psychologically and biologically inspired behavioral insights. As a matter of οἶκος, or housekeeping in social or biological terms, environmental economics unites human economy with natural ecology. Higher-moment asset pricing revives the organic connection between environmental economics and financial economics as species of human housekeeping.
This article applies higher-moment asset pricing to a wide range of valuation and decisionmaking problems in environmental economics. Part 1 of this research formally specifies a generalized higher-moment capital asset pricing model (CAPM+), according to the Taylor series expansion of logarithmic financial returns. The CAPM+ maps nicely onto prospect theory, the most familiar and widely applied model of behavioral economics.
Part II provides an overview of higher-moment asset pricing problems in environmental economics. In particular, asset pricing through formal models such as CAPM+ and its more familiar predecessor, the conventional capital asset pricing model, represents an exercise in valuation. The proper valuation of ecosystem services is an overriding concern in contemporary environmental economics. Ecosystem service valuation presents instances of skewness preference and pricing premiums associated with downside uncertainty, comovement, and kurtosis.
Part III presents a generalized model of uncertainty. It focuses on the tension between the Arrow-Lind and Arrow-Fisher theorems in environmental economics. Part IV provides greater detail into the “bonds-and-bullets” approach to portfolio construction. That strategy, which appears to describe universal preferences in financial decisionmaking, portends grim consequences for environmental economics as contemporary humanity faces multiple traps of its own device.