3. Discounting and intergenerational ethics
Climate policy generally involves near-term costs with very long-term benefits; those who stand to gain the most from actions today have not yet been born. What do economics and ethics have to say about our relationship to future generations — and about the resulting implications for discount rates?
The nature of discounting
Structural Change and Economic Dynamics, 2012, 23, 313 - 324
Abstract: From monetary policies to the climate change problem, from the burden of private credit card debts to the evaluation of public projects, discount rate is the central issue, yet there is little clear understanding about the nature of discounting. In this paper, applying a newly developed production theory, we discuss how discount rate is related to other factors in social systems, such as risk, duration of production, fixed cost in production and market size. The relations among different factors in a social system put constraints on the ranges of discount rate that are viable in particular environments. Our findings have strong policy implications. In a world of increasing cost of extracting natural resources, the continuation of low discount rate policy will generate wide gyration of social systems that we have witnessed in recent years.
Dietz, S. & Asheim, G. B.
Journal of Environmental Economics and Management, 2012, 63, 321 - 335
Abstract: Empirical evaluation of policies to mitigate climate change has been largely confined to the application of discounted utilitarianism (DU). DU is controversial, both due to the conditions through which it is justified and due to its consequences for climate policies, where the discounting of future utility gains from present abatement efforts makes it harder for such measures to justify their present costs. In this paper, we propose sustainable discounted utilitarianism (SDU) as an alternative principle for evaluation of climate policy. Unlike undiscounted utilitarianism, which always assigns zero relative weight to present utility, SDU is an axiomatically based criterion, which departs from DU by assigning zero weight to present utility if and only if the present is better off than the future. Using the DICE integrated assessment model to run risk analysis, we show that it is possible for the future to be worse off than the present along a "business as usual" development path. Consequently SDU and DU differ, and willingness to pay for emissions reductions is (sometimes significantly) higher under SDU than under DU. Under SDU, stringent schedules of emissions reductions increase social welfare, even for a relatively high utility discount rate.
Consumption tradeoff vs. catastrophes avoidance: implications of some recent results in happiness studies on the economics of climate change
Climatic Change (2011) 105(1-2): 109-127.
Recent discussion of climate change focuses on the trade-off between present and future consumption and hence correctly emphasizes the discount rate. Stern (2007) favours immediate and strong actions of environmental protection, but this has been questioned as the discount rate used is much lower than the market or commonly used rates. Focussed only on consumption trade-off, the use of these higher discount rates completely reverses the need for strong actions. However, an even more important problem has been largely neglected. This is the avoidance of catastrophes that may threaten the extinction of the human species. But "we lack a usable economic framework for dealing with these kinds of ... extreme disasters’ (Weitzman, J Econ Lit 45(3):703–724, 2007, p. 723). To analyse this, the comparison of marginal utility with total utility is needed. As happiness studies suggest a low ratio of marginal to total utility and as scientific and technological advances (especially in brain stimulation and genetic engineering) may dramatically increase future welfare, immediate and actions stronger than proposed by Stern may be justified despite high discount rates on future consumption, as discount rates on future utility/welfare should be much lower.
Climate change economics and discounted utilitarianism
Ecological Economics, 2011, 72, 45 – 52
In the recent debate on climate change economics triggered by the Stern Review and his opponents, fundamental methodological issues emerge. It becomes obvious that different choices for some variables in the models applied lead to vastly different conclusions. Specifically, the choice of the pure time discount rate d decides on whether immediate strong action (in the Stern Review) or a more moderate response (as in Nordhaus' writings) is the right strategy facing the climate change challenge. This contribution critically comments the use of both d and ?, the elasticity of marginal utility with respect to income, as "adjustment screws" in models of climate economics. Often, the models remain ambiguous as to whether they apply empirical or normative variables; facts and value judgments are not sufficiently distinguished. Furthermore, Discounted Utilitarianism appears to be a questionable fundament for climate change economics. From a non-utilitarian, specifically a Rawlsian point of view, it is pointless to maximize the utility an abstract, eternally-long lived phantasm "humanity" where no human individuals are distinguished. The more persuading position in climate economics is to postulate a duty to do everything in order to avoid serious evil for future generations.
A quantitative minimax regret approach to climate change: Does discounting still matter?
Andries F. Hof, Detlef P. van Vuuren and Michel G.J. den Elzen
Ecological Economics (2010) 70(1): 43-51.
Using cost–benefit analysis to determine an optimal climate mitigation target is criticised, especially because i) it fails to sufficiently take into account low-probability, high-impact events, and ii) results strongly depend on the discount rate used. One of the alternative suggestions to inform policymakers about the right mitigation target that does take the risks associated with low-probability, high-impact events explicitly into account is the minimax regret criterion. We apply the minimax regret criterion quantitatively using an integrated assessment model with extreme values for climate sensitivity, damage estimates and mitigation costs. The goal is to analyse whether such a method leads to different results compared to standard cost–benefit analysis and whether the results are still sensitive to the discount rate used. We find that the minimax regret approach leads to more stringent and robust climate targets for relatively low discount rates and if both a high climate sensitivity and high damage estimates are assumed. If one of these assumptions does not hold, the difference between the minimax regret approach and standard cost–benefit analysis is much smaller. Therefore, we conclude that the discount rate used can still be of vital importance even when applying a minimax regret approach.
Risk-adjusted gamma discounting
Martin L. Weitzman
Journal of Environmental Economics and Management (2010) 60(1): 1-13.
It is widely recognized that the economics of distant-future events, like climate change, is critically dependent upon the choice of a discount rate. Unfortunately, it is unclear how to discount distant-future events when the future discount rate itself is unknown. In previous work, an analytically-tractable approach called "gamma discounting" was proposed, which gave a declining discount rate schedule as a simple closed-form function of time. This paper extends the previous gamma approach by using a Ramsey optimal growth model, combined with uncertainty about future productivity, in order to "risk adjust" all probabilities by marginal utility weights. Some basic numerical examples are given, which suggest that the overall effect of risk-adjusted gamma discounting on lowering distant-future discount rates may be significant. The driving force is a "fear factor" from risk aversion to permanent productivity shocks representing catastrophic future states of the world.
Social discounting under uncertainty: A cross-country comparison
Cameron Hepburn, Phoebe Koundouri, Ekaterini Panopoulou and Theologos Pantelidis
Journal of Environmental Economics and Management (2009) 57 (2): 140-150.
Recent research suggests that social cost-benefit analysis should be conducted with a declining discount rate. For instance Newell and Pizer [Discounting the distant future: how much do uncertain rates increase valuations? J. Environ. Econ. Manage. 46 (2003) 52–71] show that the US certainty-equivalent discount rate declines through time, using a simple autoregressive model of US interest rates. This paper extends that line of research, estimating both autoregressive and regime-switching models of real interest rates to determine certainty-equivalent discount rates in Australia, Canada, Germany and the UK. It is found that the regime-switching model is a better model of past interest rate behavior for all four countries. This model tends to produce a more rapid decline in certainty-equivalent discount rates. The paper provides applications to the economics of climate change and nuclear power.
Rethinking the theory of discounting and revealed time preference
Richard B. Howarth
Land Economics (2009) 85: 24-40.
Benartzi and Thaler (1995) suggest that direct preferences regarding investment gains and losses strongly affect people’s behavior in financial markets. The article shows that this hypothesis has striking implications for the choice of discount rates in cost-benefit analysis. The paper explores a model in which the future benefits provided by a generic public good – environmental quality – should be discounted at a rate that is close to the market rate of return for risk-free financial assets. This holds true even when the public good is in the same risk class as risky forms of wealth such as corporate stocks.
The behavioural economics of climate change
Kjell Arne Brekke and Olof Johansson-Stenman
Oxford Review of Economic Policy (2008) 24(2): 280-297.
This article attempts to bring some central insights from behavioural economics into the economics of climate change. In particular, it discusses (i) implications of prospect theory, the equity premium puzzle, and time-inconsistent preferences in the choice of discount rate used in climate-change cost assessments, and (ii) the implications of various kinds of social preferences for the outcome of climate negotiations. Several reasons are presented for why it appears advisable to choose a substantially lower social discount rate than the average return on investments. It also seems likely that taking social preferences into account increases the possibilities of obtaining international agreements, compared to the standard model. However, there are also effects going in the opposite direction, and the importance of sanctions is emphasized.
Economists, value judgments, and climate change: A view from feminist economics
Julie A. Nelson
Ecological Economics (2008) 65(3): 441-447.
A number of recent discussions about ethical issues in climate change, as engaged in by economists, have focused on the value of the parameter representing the rate of time preference within models of optimal growth. This article examines many economists' antipathy to serious discussion of ethical matters, and suggests that the avoidance of questions of intergenerational equity is related to another set of value judgments concerning the quality and objectivity of economic practice. Using insights from feminist philosophy of science and research on high reliability organizations, this essay argues that a more ethically transparent, real-world-oriented, and flexible economic practice would lead to more reliable and useful knowledge.
Why Stern was right: Time preference, risk, and the economics of climate change
Richard B. Howarth
Revue de Philosophie Économique (2008) 9 (published in English): 91-100.
Based on the utilitarian premise that equal weight should be attached to the welfare of present and future generations, the Stern Review concludes that deep reductions in greenhouse gas emissions are morally justified. Critics charge that Stern’s premise is inconsistent with the preferences people reveal in real-world decisions. Evidence from financial markets, however, suggests that people have low rates of time preference and high rates of risk aversion — facts that are generally consistent with Stern’s formal model. Moreover, deep emissions cuts may be justified by the premise that present decision-makers have no right to impose uncompensated harms on posterity. In this sense, Stern’s findings do not depend strongly on his specific moral argument.
Discounting climate change
Journal of Risk and Uncertainty (2008) 37: 141-169.
In this paper I offer a fairly complete account of the idea of social discount rates as applied to public policy analysis. I show that those rates are neither ethical primitives nor observables as market rates of return on investment, but that they ought instead to be derived from economic forecasts and society's conception of distributive justice concerning the allocation of goods and services across personal identities, time, and events. However, I also show that if future uncertainties are large, the formulation of intergenerational well-being we economists have grown used to could lead to ethical paradoxes even if the uncertainties are thin-tailed. Various modelling avenues that offer a way out of the dilemma are discussed. None is entirely satisfactory.
Equity effects of alternative assignments of global environmental rights
Stephen J. DeCanio and Paul Niemann
Ecological Economics (2006) 56(4): 546-559.
Through a thought experiment in which members of different generations trade with each other in a virtual market, we examine the effects of alternative assignments of global environmental rights on prices, interest rates, and the global distribution of income. The model is "semi-calibrated" to current and projected levels of the output of produced goods and to present and future quantities of global environmental goods. Income classes in each country are disaggregated to the quintile level. Multiple equilibria are possible for some rights assignments, with implications for intergenerational equity. The model projects bounds on the degree of future economic inequality depending on how the environmental rights are assigned. A policy that assigns the environmental rights in such a way as to leave the present-day distribution of income unchanged while moving in the direction of equal per capita endowments of environmental rights can result in future inequality comparable to today’s average within-country inequality.
Valuing future life and future lives: A framework for understanding discounting
Journal of Economic Psychology (2006) 27: 667–680.
This article offers a conceptual framework for separating the distinct theoretical concepts that are often confounded in discussions of discounting. Two distinctions are emphasized: (a) the difference between discounting a future outcome because it confers less utility and discounting future utility per se, and (b) the differences between discounting one’s own future utility and discounting the utility of others who will be alive in the future. Within this framework, I discuss and clarify the continuing controversy over discounting future life and future lives.
Do declining discount rates lead to time inconsistent economic advice?
Anders Chr. Hansen
Ecological Economics (2006) 60(1): 138-144.
This paper addresses the risk of time inconsistency in economic appraisals related to the use of hyperbolic discounting (declining discount rates) instead of exponential discounting (constant discount rate). Many economists are uneasy about the prospects of potential time inconsistency. The paper discusses whether they have reason to be uneasy. The answer is no. The risk of reversing previous recommendations due to the passing of time alone is not severely larger for hyperbolic discounting than it is for exponential discounting. And it can be managed by the same rules of precaution normally used in long term strategic policy decisions and institutional reforms.
Discounting and sustainability: Towards reconciliation
Richard B. Howarth
International Journal of Sustainable Development (2003) 6(1): 87-97.
This paper examines the well-known tension between discounting and sustainability in the long-term management of environmental resources. It describes a rights-based ethical framework in which present decision-makers hold a moral duty to ensure that life opportunities are sustained from generation to generation. Maintaining opportunities requires that natural resources must either be conserved or replaced with proven substitutes that provide equivalent services. In this framework, discounting procedures are useful in characterizing decision-makers’ preferences concerning tradeoffs between costs and benefits that arise at different points in time. Such preferences, however, are trumped by duties to posterity in cases where discounting favors the uncompensated depletion of resource stocks.
Discounting and uncertainty in climate change policy analysis
Richard B. Howarth
Land Economics (2003) 79(3): 369-381.
Economic studies of climate change commonly discount the future at a rate equal to the long-run return on corporate stocks. Stock market returns, however, are dominated by a risk premium, while climate change mitigation measures would reduce important risks to future welfare. Drawing on the theory of investment behavior under uncertainty, this paper argues that the benefits of climate stabilization policies should be discounted at a rate equal to the annual return on risk-free financial assets, which attains an empirical value between 0 and 2.6%. In addition, expected benefits must be adjusted to account for the value of risk abatement.
Measuring intergenerational time preference: Are future lives valued less?
The Journal of Risk and Uncertainty (2003) 26(1): 39–53.
Prior research has estimated intergenerational time preferences by asking respondents to choose between hypothetical life saving programs. From such choices, researchers have concluded that the public heavily discounts the lives of people in future generations. However, using a multiversion survey involving 401 respondents, this article shows that imputed intergenerational time preferences can be dramatically affected by the specific question that is asked. Different elicitation procedures can yield widely varying results by evoking or suppressing various relevant considerations (such as uncertainty). Many formats revealed no preference for current generations over future generations.
Discounting the distant future: How much do uncertain rates increase valuations?
Richard G. Newell and William A. Pizer
Journal of Environmental Economics and Management (2003) 46: 52-71.
We demonstrate that when the future path of the discount rate is uncertain, the distant future should be discounted at significantly lower rates than suggested by the current rate. We then use two centuries of US interest rate data to quantify this effect. Using both random walk and mean-reverting models, we compute the ‘‘certainty-equivalent rate’’ that summarizes the effect of uncertainty and measures the appropriate forward rate of discount in the future. Under the random walk model, the certainty-equivalent rate falls continuously from 4% to 2% after 100 years, 1% after 200 years, and 0.5% after 300 years. At horizons of 400 years, the discounted value increases by a factor of over 40,000 relative to conventional discounting. Applied to climate change mitigation, incorporating discount rate uncertainty almost doubles the expected present value of mitigation benefits.
Time discounting and time preference: A critical review
Shane Frederick, George Loewenstein and Ted O’Donoghue
Journal of Economic Literature (2002) XL (June): 351–401.
A very thorough, extensive literature review, presenting both the rich history of economic thought about time preference prior to Samuelson’s 1937 codification of discounted utility, and the numerous newer alternatives to fixed discount rates that have appeared in more recent economics literature.
Intertemporal social choice and climate stabilization
Richard B. Howarth
International Journal of Environment and Pollution (2001) 15: 386-405.
This paper examines the implications of alternative approaches to Intertemporal social choice in a numerically calibrated model of interactions between global climate change and the world economy. Under cost-benefit analysis, relatively modest steps toward greenhouse gas emissions abatement are justified as economically efficient. Under classical utilitarianism and the precautionary principle, in contrast, aggressive steps toward climate stabilization emerge as socially optimal. The paper reviews the value judgments that support each of these normative approaches, arguing that the precautionary principle is most closely tied to the goals and objectives of the Framework Convention on Climate Change.
Global warming: Discounting is not the issue, but substitutability is
Energy Policy (1999) 27: 33-43.
The cost-benefit study of Nordhaus (1994), a leading representative of the neoclassical approach toward global warming, found that no substantial emission cuts are warranted. Most of his critics have concentrated on the issue of discounting. These criticisms miss the point because the real problem of Nordhaus’s methodology is his implicit underlying assumption of perfect substitutability between natural and other forms of capital. Given the validity of this assumption, lowering the rate of discount is inconsistent with current savings behaviour, is ethically dubious because future generations will be much richer than the current one anyway, and is inefficient because scarce financial resources are channeled into emissions abatement that exhibits rates of return far inferior to alternative public investments. Any call for aggressive emission abatement must therefore attack the assumption of perfect substitutability. The real disagreement is about whether consumption growth can compensate for environmental degradation caused by global warming. Discounting is not the issue, but substitutability is.
Why the far-distant future should be discounted at its lowest possible rate
Martin L. Weitzman
Journal of Environmental Economics and Management (1998) 36(3): 201-208.
A critical feature of the distant future is the current uncertainty about what will then be the appropriate rate of return on capital to use for discounting. This paper shows that there is a well-defined sense in which the ‘‘lowest possible’’ interest rate should be used for discounting the far-distant future part of any investment project. Implications are discussed for evaluating long-term environmental activities, such as measures to mitigate the effects of global climate change.
Environmental valuation under sustainable development
Richard B. Howarth and Richard B. Norgaard
American Economic Review Papers and Proceedings (1992) 82: 473-477.
This paper applies an overlapping generations model to show that optimal climate-change policies are sensitive to the distribution of welfare between generations. In this model, transferring wealth to future generations both lowers discount rates and increases the future value of environmental resources, thereby favoring reductions in greenhouse gas emissions. This illustrates a basic point from the theory of cost-benefit analysis: Alternative assignments of property rights lead to different Pareto-efficient resource allocations. Overlapping generations models decouple the concept of personal time preference from the moral values used to evaluate tradeoffs between the welfare of present and future generations. This approach is conceptually superior to standard optimal growth models, in which a single parameter is used to represent both personal time preference and the relative weight attached to the welfare of future generations.