Beneath the trees: the influence of natural capital on shadow price dynamics in a macroeconomic model with uncertainty

Download
The rapid degradation of Earth’s ecosystems has significant implications for economic production. To assess those implications, in this paper the authors build a macroeconomic model that includes natural capital and ecosystem dynamics and is subjected to uncertainty. The findings indicate that the social cost of carbon is 12% higher in a model incorporating natural capital compared with a standard DICE-type model.
The study highlights the importance of considering natural capital and the role of uncertainty in macroeconomic models. Ignoring natural capital can lead to substantial underestimation of the social cost of carbon and other shadow prices, ultimately affecting policy decisions and long-term sustainability. Moreover, this paper presents new estimates of climate damages and elasticities of substitution between different forms of natural capital in production, demonstrating that shadow prices vary across these parameter calibrations and model specifications.
Key points for decision-makers
- Natural capital, encompassing natural resources like forests ecosystem services, minerals and cropland, is crucial for economic production and human wellbeing. Natural capital is being damaged by climate change caused by economic activity.
- The findings indicate that the social cost of carbon – a value representing the monetary impacts of climate damage – is 12% higher in a model incorporating natural capital compared with a standard DICE-type model (an integrated assessment model that explores the interactions between the economy and climate).
- Furthermore, the social cost of carbon is highly sensitive to the elasticity of substitution (or the ease of switching between inputs) in the final output production function.
- Accounting for the stochastic nature of productivity – the way that economic productivity levels are not entirely predictable – further increases the social cost of carbon by 0.13–39%, depending on whether habit formation is included.
- Overall, the paper’s contributions provide a deeper understanding of the economic value of natural capital and underscore the necessity of integrating it into economic models for sustainable development.