By Richard Boyd, Director of Research, All One Sky Foundation
Unless you’re an economics nerd, you've likely not heard of “discount rates”. Behind this technical term, however, lies one of the more contentious debates at the heart of how we deal with climate change.
How much is it worth to us today to avoid climate impacts later this century and beyond? This may seem like an abstract economic question, but the choice of discount rate is probably the single most important factor for analysing the costs and benefits of whether we should act urgently and aggressively now or at leisure.
Before engaging with the debate, let’s clarify some key ideas. When it comes to climate change, there’s a substantial time lag between cause-and-effect. Heat-trapping gases emitted today will affect global temperatures in around 50 years, with some of the worst impacts of climate change likely to unfold over centuries—in other words, during the lifetimes of our children, grandchildren and great-great-great grandchildren. This time lag complicates decisions to do something about climate change, because the benefits of reductions in heat-trapping gases — in terms of damages avoided — accrue to future generations, while the costs are borne by us today.
This means the policy challenge is to determine how much future climate mitigation is worth to us today in order to avoid impacts to future generations? This is where discount rates enter the picture. Discount rates provide a means for establishing equivalency over time. To get our heads around discount rates, suppose you invested $1000 in a savings account at an annual interest rate of 3% (you did well!) Your investment will grow to $1030 in a year’s time—and with compound interest, reach $1806 in 20 year’s time. We could also say that a benefit of $1806 in 20 year’s time is equivalent to a benefit of $1000 today, or that the “present value” of $1806 in 20 years is $1000 at an annual discount rate of 3%. Just think of discounting like compounding interest, but only run in reverse, and the percentage amount that a benefit declines in value each year it extends into the future, as the discount rate.
Great! We know what discount rates are. Not terrible exciting, but stick with me, they really do matter. Things get a lot more complicated when it comes to climate change and its long time horizons. Consider a scenario in which the discount rate is 3% annually (the “social discount rate” recommended by the Treasury Board of Canada for projects with impacts over 50 years or more) and we face $100 billion of damages attributable to climate change in 2100 (roughly 81 years from now); it will be worth a meager $9.1 billion to us today to avoid it. It gets more absurd if we apply a discount rate of 8% per year, which is the base rate recommended by Treasury Board of Canada. That would mean avoiding $100 billion in damages in 2100 is worth only $0.2 billion today. Hardly anything. So, you see: at discount rates in the 3-8% range, it’s difficult to justify spending much of anything on climate mitigation today. But this does not match what many people believe is reasonable when it comes to the welfare of our children and grandchildren.
So, what should the discount rate be? What number should we use when modeling climate mitigation policy? Should it be constant over time? How do we decide?
Stating the obvious, there is a vast technical literature on this subject which is vigorously debated. I only scratch the surface in this post. If you want to dig into it, but avoid mind boggling academic journals, start with the great summary prepared by Resources for the Future and then move onto the suggested further reading.
There are essentially two schools of thought when it comes to the discount rate. Scholars who argue for a relatively high discount rate (in the 3-8% range), like Noble Prize winner William Nordhaus, favor what is termed a “descriptive” approach to discounting. Proponents of this approach believe that the discount rate should be based on people’s preferences for the present over the future as revealed by their behavior in markets (i.e., by looking at prevailing market interest rates). Other scholars, like Sir Nicholas Stern, believe that it is the government’s moral duty to determine—from first principles—the discount rate that ought to be applied across generations on ethical grounds, rather than inferring the rate from the limited number of individual’s who influence market rates today. After all, those in the future who will be impacted by climate change, have no say over current market returns. This, so-called “prescriptive” approach, produces a relatively low discount rate (in the 1-3% range).
Besides the choice of how to set the discount rate, there is also the question of whether and how it might change over time. Scholars now accept that there is a compelling case for the discount rate to fall as the time horizon increases (beyond 30-50 years), due primarily to uncertainty about the future.
I find arguments for using a lower discount rate more persuasive. This does not strike me as a decision void of ethical judgements. We are talking about how much climate change we leave behind for our children, grand-children and great-grandchildren to deal with.
Now you understand the issues, join the debate — figuring out the correct discount rate and process for climate policy in Canada is so important.