www.ijesci.

org InternationalJournalofEnergyScience(IJES)Volume3Issue3,June2013
156
MotivationofClimateChangeInvestment
andRiskExposure
NewPerspectivefromGameModel
CanWang
*1
,ZhugangJin
2
,WenjiaCai
3
MinistryofEducationKeyLaboratoryforEarthSystemModeling,andCenterforEarthSystemScience,Tsinghua
University;StateKeyJointLaboratoryofEnvironmentSimulationandPollutionControl(SKLESPC),andSchoolof
Environment,TsinghuaUniversity
Room1004,SinoItalyEnvironmentandEnergyBuilding,TsinghuaUniversity,Beijing,China,100084
*1
canwang@tsinghua.edu.cn(CorrespondingAuthor);
2
xshs20071727@126.com;
3
wcai@mail.tsinghua.edu.cn

Abstract
The common and individual uncertainties are the main
factors influencing the motivation of climate change
investmentforeachcountry.Bydistinguishingandinvolving
the three effects of climate change investment on utility,
strategicgamemodelwithrationalityhypothesisisproposed
and simulated to evaluate the relationship between the
investment motivation and individual risk exposure due to
individualuncertainties.Thepositivecorrelationbetweenthe
risk exposure and investment motivations is confirmed. The
negative influences of risk exposure on utilities of game
equilibriumswhateverthedynamicstrategiesarealsotested.
Upgradeofthestructureofeconomyandenhancementofthe
antifluctuation capacity for the economy shock of global
warmingdeservetobethefocusandpriority.
Keywords
Investment;RiskExposure;ClimateChange;GameModel
I nt r oduc t i on
Over the past several decades, global warming and
climate negotiation have become more and more
severe in spite of the progress on the scientific and
sociological researches. Theres still a huge gap
between the attitudes towards the responsibility and
schedule of implementation. Apart from political and
economic concerns, the uncertainties of global
warming together with its impact are the major
obstacles on the way to reaching a widely acceptable
andbindingconsensusforallcountries.EUinsiststhat
actions should be taken immediately due to
irreversible risk of temperature increment on human
beings living environment, while the United States
believesthatitseconomicalandfeasibletomakeuseof
future technology progress to cope with the issue.
Different perspectives on the reaction to uncertainties
are the essential factors destabilizing the direction of
climatenegotiation.
Generally,theuncertaintiesasmentionedabovecanbe
classified into two categories: common uncertainties
and individual uncertainties. The global greenhouse
gas (GHG) concentration and the temperature
increment together with its trajectory under BAU
(businessasusual)scenariointhefuturebelongtothe
former type as its confronted in each country fairly.
Although the temperature increment due to the GHG
concentration is triggered by the combined effects of
individualmitigationfundamentally,theexternalityof
GHG results in the lack of motivation to conduct
carbonabatementforeachcountryalone.Chanderand
Tulkens (2006), Wood (2011) and other researchers
(Desombre, 2004; Hovi, Sprinz and Bang, 2012; Kroll
andShogren,2008)havealreadyrevealedthefailureof
cooperation from perspective of theoretical game
theory.
The other type of uncertainty is based on individual
properties including initial GDP growth, the tolerance
oftemperatureincrementonindividualGDPetal.The
diversities of industry structures and choices of
competitive industries may affect the stabilities and
risk resistance capacities for each country under
different temperature increment scenarios. Compared
with developed countries, the developing countries,
especially the African and Southeast Asian nations
maysuffermoreseverlosswithhigheruncertaintyfor
their inadequate precaution and high dependence on
thetenderagricultureindustry(Hope,2006;Maddison,
2003; Nordhaus and Boyer, 2000; Tol, 2002). Such risk
exposures connected with individual properties may
attract more attention for their own interests and
trigger their subjective initiatives. Then the way how
the risk exposure will influence the negotiation
strategies is introduced. Such relationship is
investigated in this article with theoretical model and
InternationalJournalofEnergyScience(IJES)Volume3Issue3,June2013 www.ijesci.org
157
simulations. Based on rationality hypothesis, the three
effects of climate change investment on utility are
distinguished and involved in our dynamic game
model.Simulationtogetherwithcomparisoniscarried
out. More information about the model is introduced
in Section 2. Simulations together with evaluation are
presented in Section 3, followed by discussions and
conclusionsinSection4.
Theor et i c al Model
UtilityandUncertainties
We posit a constant relative risk aversion (CRRA)
socialutilityfunctionforeachrationalcountry:
1
,
,
.
1
i
i t t t
i i t
i
C
Utility e U dt e dt
q
o o
q

= =

} }
(1)
where Utilityi, Ui,t,
i
q ando refer to the net present
utility, utility at time t, index of risk aversion and
discounting rate for country i respectively. Ci,t means
the disposable consumption at time t which can be
connectedwithGDPgrowthrategt:
0
( ).
t
t s
C exp g ds =
}
(2)
In the absence of global warming, real GDP and
consumption can keep a constant growth g0, but the
temperature increment would have a simplified linear
effect on real GDP growth as Dell, Jones and
Olken(2009)estimated:
0
.
t t
g g T = (3)
Themarginaleffectoftemperatureincrementattimet
(Tt) on GDP growth is . As just discussed, the
temperature increment and the marginal effect
parameter belong to the two categories of
uncertainties respectively. Although lots of researches
have calibrated these parameters, the results are not
alwaysconsistentorpreciseduetovariousrestrictions
ofeachmodel.Oneofthewidelyacceptedsolutionsis
to involve probability theory and to estimate the
expectedutility.
For the common uncertainty, i.e. Tt, the temperature
increment at horizon year (H=100) has been fitted by
Pindyck(2012), Newbold and Daigneault(2009) with
assumptions that the mean, 5% and 1% points
temperature increments are 3, 7and
10respectively. Threeparameter (i.e. , ,
T T T
r u )
Gamma function fits the uncertainty distribution well
withthefollowingPDF(probabilitydensityfunction):
1 ( )
( ; , , ) ( ) , .
( )
T
T T T
r
r x T
T T T T T T
T
f x r x e x
r
u

u u u

= >
I
(4)
For the individual uncertainty, i.e , the marginal
effectoftemperatureincrementonGDPgrowthcanbe
calibrated based on the individual exponential loss
function information obtained from IAMs researches
as there is a linear relationship between | and
theoretically
1
. Given the trajectory of temperature
incrementTtproposedbyWeitzman(2009)andapplied
by Pindyck(2012), Figure 1 shows the change of loss
function value due to the temperature increment at
horizonyear,parameter | andtimet.
2
( )
( ) .
T
Loss T e
|
= (5)
/
1
2 [1 ( ) ].
2
t H
t H
T T =
(6)
0
2
4
6 0
50
100
0.65
0.7
0.75
0.8
0.85
0.9
0.95
1

t
TH
L
o
s
s
Beta=0.0082
Beta=0.0169

FIG.1THERELATIONSHIPSOFLOSS(TT),T,THAND
EffectsofClimateChangeInvestmentand
Motivations
The three effects of climate change investment on
utility are distinguished: the positive, negative and
spillover effects. If invi represents the percentage of
climate change investment to GDP for country i, then
theamountofdisposableconsumptionwillbereduced
whichisdefinedasthenegativeeffectofinvionutility.
On the other hand, climate change investment will
boost the original GDP growth with marginal
parameter as its implemented as extra investment.

1
WithEq.(1)to(6),thetheoreticalrelationbetween
and | canbesolvedout:
1
[2 ]
(0.5)
H
T
H
ln
| =
+

www.ijesci.org InternationalJournalofEnergyScience(IJES)Volume3Issue3,June2013
158
Therefore the modified GDP growth and disposable
consumption due to the positive and negative effects
areadjustedas:
*
, ,0
(1 ) .
i t i i i i t
g g inv T = +
(7)
* *
, , ,
0
(1 ) (1 ) ( ).
t
i t i t i i i s
C C inv inv exp g ds = =
}
(8)
On the other hand, the externality ofglobal warming
determines the spillover effect of climate change
investment. Supposing that the relationship between
the upper boundary of temperature increment TUpand
global climate change investment can be quantified as
function u, then each countrys investment decision
inviwillpartiallyinfluencetheTUpwithitsGDPrelated
weighting factor w indirectly. Compared to the
temperature increment uncertainty under no
investment scenario, TUp should promote each
countryspresentnetutilityastheoriginaldistribution
ofcommonuncertaintywillbeupdatedwithBayesian
theorem. In other words, the original PDF for the
temperature increment in the future ( ; , , )
T
f x r u is
Bayesianupdatedto ( ; , , )
T
f x r u

asEq.(10)shows:
= ( )= ( ).
Up world i i
i
T inv w inv u u

(9)
( ; , , )
( ; , , ) , .
( ; , , )
Up
T
T
T UP T
T
f x r
f x r x T
f x r dx
u
u
u u
u
= s s
}

(10)
1 *
,
0
( )
= ( , ; )= .
1
Up i
i i
T i
T
i t t
i i i j T
i
C
Utility inv f inv e f f dTd dt

q
o

u u

q
+ +

} } }

(11)
If the three effects of climate change investment are
combined, every rational negotiator has incentives to
choose the optimal investment to maximize its own
utility. Apart from common uncertainties, individual
uncertainties will also affect their motivations. By
means of integration of the Eq. (1) to (10), the present
net utility of country i can be further expressed
as ( , ; )
i
i i j
inv f inv

+ . Given the other countries

investment information invj and individual
uncertainty
i
f

, the optimal amount of climate change

investment for county i should meet the target of
maximum
i
+ .Hence,
= ( ; )
i
i i j
OptInv f inv

O
isemployed
to represent the optimal reaction which is determined
by invj and individual uncertainty
i
f

. By comparing
the gap of OptInvi under different assumption of
i
f

,
the relationship of climate change investment
motivationandriskexposurethencanbeevaluated.
Furthermore, the noncooperative game equilibriums
can also be worked out by involving the dynamic
decision steps for each country under complete
information hypothesis. The influence of individual
uncertainty
i
f

on the game equilibriums can be

examined as well. With the backward induction
method (Aumann, 1995), the theoretical game
equilibriumsofdynamicgamemodelfortwocountries
involve three scenarios as table 1 shows.
First, second and simul mean the three strategies,
and
/ / first second simul
i
OptInv ,
/ / first second simul
i
Utility represent
climate change investment and utility of equilibriums
respectively.
Si mul at i on and Compar i sons
For the individual uncertainty, three groups with
differenthypothesesaresimulatedandcompared.The
probability density function
i
f

is fitted by taking the

mean loss for TH=2.5 to be 3% GDP, and the 17%
point and 83% point to be 1% and 4.8% of GDP
respectively for Group 1. The risk exposures are
adjusted by means of increasing and decreasing the
variance with the same expectation for Group 2 and
Group 3 respectively.
2
Figure 2 shows the distribution
ofparameter .Generally,theriskexposuremeetsthe
order:Group2>Group1>Group3.
In comparison with the optimal reactions of three
groupsasFigure3shows
3
,theoptimalreactiontohigh
riskexposure country tends to be morethan that with
lowriskexposure.Wheninvj=3%,theoptimalreaction
of Group 1 is 1.248% GDP, higher than 1.246% of
Group3andlowerthan1.251%ofGroup2respectively.
The simulation results are rational and in accordance
with the reality because the optimal reaction refers to
anoptimalbalanceofthethreeeffectsofclimate

2
ForthreeparameterGammadistribution,themean,
varianceandskewness
are ( ) / E x r u = + ,
2
( ) / Var x r =
and
3
( ) 2 / Skew x r = respectively.
3
TheothercommonparametersincludeinitialGDP
growthg0=4.5%,riskaversion 2 q = ,marginalpromoting
effectofclimatechangeinvestmentonGDPgrowth 1 = ,
timepreference 0 o = andinitialtemperatureuncertainty
( ) 3.8, ( , 0. , 92, 1. 3 ) 1
T T T
r u = whichisinaccordancewith
Pindyck(2012).
InternationalJournalofEnergyScience(IJES)Volume3Issue3,June2013 www.ijesci.org
159
TABLE1THEORETICALEQUILIBRIUMSFORDYNAMICGAMEMODELWITHTWOCOUNTRIES
Scenarios CountryImovesfirstly Countryjmovesfirstly Simultaneously
Countryi ,
first first
i i
OptInv Utility

,
second second
i i
OptInv Utility ,
simul simul
i i
OptInv Utility
Countryj ,
second second
j j
OptInv Utility

,
first first
j j
OptInv Utility ,
simul simul
j j
OptInv Utility
Notes:Thistableonlysimulatestwocountryscenariowhichcanbeadjustedtothemulticountrysituation.
TABLE2HYPOTHESESANDCALIBRATIONRESULTSFORINDIVIDUALUNCERTAINTY

Hypothesesof(1Loss(2.5))
Threeparametersfor

Mean 17%Point 83%Point r

u
Group1 3% 1% 4.8% 11.141 22329 2.85E04
Group2 3% 0.5% 5.3% 6.935 13815 2.87E04
Group3 3% 1.5% 4.3% 20.72 41624 2.85E04
Notes:theparametervaluesfor areinaccordancewiththehypothesesrespectively.
TABLE3NONCOOPERATIVEDYNAMICGAMEMODELEQUILIBRIUMSOFTHREESTRATEGYSCENARIOS
imovesfirstly jmovesfirstly Simultaneously
Group1 Group2 G3 G1 G2 G3 G1 G2 G3
OptInvi 1.342% 1.343% 1.341% 1.337% 1.336% 1.334% 1.341% 1.339% 1.337%
OptInvj 0.455% 0.455% 0.455% 0.560% 0.560% 0.560% 0.455% 0.454% 0.454%
Utilityi 21.7745 21.7756 21.7738 21.7745 21.7756 21.7738 21.7745 21.7756 21.7738
Utilityj 66.4760 66.4760 66.4760 66.4760 66.4760 66.4760 66.4760 66.4760 66.4760
-4 -2 0 2 4 6 8 10
x 10
-4
0
500
1000
1500
2000
2500
3000
3500
4000
Parameter r
P
D
F


Group 1
Group 2
Group 3

FIG.2PROBABILITYDENSITYDISTRIBUTIONOFPARAMETER
FORGROUP1TO3
0.026 0.027 0.028 0.029 0.03 0.031 0.032 0.033
0.0123
0.0124
0.0124
0.0125
0.0125
0.0126
0.0126
0.0127
inv
j
O
p
t
I
n
v
i


Group 1
Group 2
Group 3

FIG.3 = ( ; )
i
i i j
OptInv f inv

O FORGROUP1TO3
change investment. With higher risk exposure, the
room of improvement in spillover effect would be
more attractive and significant, which will trigger the
higher investment of climate change. In other words,
high risk exposure will promote the motivation of
climatechangeinvestment.
Inaddition,dynamicgameequilibriumsinTable3also
show the differences due to the risk exposures
4
.
Although the equilibriums of investment are not
consistentineachdynamicstrategyscenario,theutility
differences are significant. Whatever the dynamic
strategy scenario is, the utility of country i meets the
order constantly: Group 3>Group 1> Group2. The
simulation results are also inspiring. It indicates that
the risk exposure itself has much more determining
powerthanthegamestrategiesundernoncooperative
scenarios in influencing the utilities of each country,
which means that we should give the priority to the
enhancement of the antifluctuation capacity for the
economyshockofglobalwarming.
Di sc ussi ons and Conc l usi on
The effects of risk exposures on optimal reactions
together with game equilibriums are evaluated. By
distinguishing the three effects of climate change
investmentonutility,themotivationofclimatechange
investmentareinvestigatedwithrationalityhypothesis.
Simulationsresultsrevealthatthehigherriskexposure

4
Theothercountry/sectorjmeetthefollowinginitial
hypotheseswhichisbasedonreality:
g0,j=1.5%, 1 = , 0 o = and
( ) 103.8,411600 ( , , , 1.745 ) 4 r e

u =
.
www.ijesci.org InternationalJournalofEnergyScience(IJES)Volume3Issue3,June2013
160
is,themoreinvestmentonenationisincentivetomake,
whichmeansthatthefragilityofeconomymayhavea
significanteffectonthemotivations.Forcountrieswith
highdependence on agriculture and other industries
susceptible to global warming, its rational and
motivated to invest more. Therefore, its advisable for
developingcountries,especiallyAfricanandSoutheast
Asiannationstoupgradetheindustrystructureandto
takeprecautionstocopewiththefluctuationofclimate
change, which will not only be conductive to the
stability of future utility, but also enhance their
bargainingpowerinclimatenegotiation.Moreover,the
results of game equilibriums under different dynamic
strategies also suggest the benefits of reduction of the
risk exposure. Countries with higher risk exposure
may have to face more severe decrease of utility. Such
decrement is significant whatever the adopted
dynamic strategies are, leading to the cognition that
more attention should be paid to the improvement of
economy structure and antifluctuation capacity
comparedtothenegotiationstrategiesthemselves.
ACKNOWLEDGMENT
This research was funded by the National Natural
ScienceFoundationofChina(No.71273153).
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