Ambiguity vs. Risk in Investment Decisions: An Illustration from Green Finance

Does ambiguity (Knightian uncertainty) or risk provide a greater discouragement to investment? There is general agreement in the financial press that uncertainty discourages investment, with uncertainty here meaning any situation where important future policy variables (such as tariffs or tax rates) are not known. And it seems intuitively plausible that situations of ambiguity are “more uncertain” than those of risk: under risk, although the outcome is not known, its expected value is, whereas under ambiguity we have a distribution of possible expected values. In this paper we investigate this issue, and show that under quite general circumstances it is the case that ambiguity deters investment more than an equivalent risk. We define an equivalent risk as one characterized by a compound lottery reflecting the ambiguous situation, but without ambiguity aversion. We show that there will always be investments opportunities that are rejected when characterized by ambiguity but are accepted when characterized by risk with an equivalent compound lottery, and that the converse is not true: there are no investments that would be made under ambiguity that would not be made under equivalent risk. This conclusion is not obvious: in a companion paper on regulatory ambiguity in green investments [heal2025], we show that when ambiguity affects returns to both investment options but in opposite ways, ambiguity can actually encourage investment in the green option.

We develop the analysis in the context of the emerging field of green finance, and in particular the financing of opportunities for biodiversity conservation and for greenhouse gas mitigation. Billions are being invested in green bonds, renewable energy, and carbon markets; however, the pace of this transition lags climate targets - a puzzle that standard economic models struggle to explain. Risk-based frameworks predict a robust shift toward green investments when they offer competitive expected returns. Yet firms hesitate, capital stalls, and brown assets persist.