A guest commentary by Dr. Richard Rosen, Tellus Institute (retired)
It is a fairly well-known fact that the Inter-governmental Panel on Climate Change (IPCC) relies almost exclusively on economically-driven integrated assessment models (IAMs) to create long-term mitigation scenarios. And those IAMs utilize the well-known concept of discount rates, as is typically the case for economic models. These discount rates help to prioritize the timing of major investments in technologies to mitigate climate change between the distant future (which often includes negative emissions technologies), and the near term which primarily includes renewable energy technologies. But that is a very serious problem when high discount rates are utilized, because the world has already delayed too long in attempting to mitigate climate change. This issue is, therefore, very important for the current debate on whether or not the world should aim to keep the increase in global temperatures to an average of 1.5°C, or whether such a strict target is already impossible to achieve, such that we must settle for a 2.0oC target. I will now explain why it is crucial to focus on the values for the discount rates assumed in the IAMs relied on by the IPCC.
One of the oldest debates within environmental economics is whether for any particular environmental issue it is appropriate to perform some sort of multi-year economic analysis, and if it is appropriate to do so how should the economic results for individual years be compared to each other. By “compared to each other” we mean in most cases how should the numerical results in each year be weighted prior to adding them up in order to derive a total economic impact over some relevant time period. For example, if investment in a local water treatment plant were being considered, environmental economists might deem it appropriate to try to compute the yearly economic costs and benefits from investing in such a project over the likely lifetime of the treatment plant. If the benefits exceed the costs they might conclude that this investment ought to be made. But the key question always arises as to how the costs and benefits in different year during this time period should be weighted. Often a simple discount rate is utilized, which is similar to an inflation rate used to compare one year’s inflation adjusted euros to euros spent in another year after some degree of inflation occurred. Thus, if a 2% real discount rate were used in a particular calculation, the inflation-adjusted euros spent in year 2 would be reduced by 2% when they were added to the inflation-adjusted euros spent in year 1. Similarly, the inflation-adjusted euros spent in year 3 would be devalued by about 4% when added to the year 1 euros. We can easily see from this example that the discount rate serves to “devalue” the costs and benefits that occur in future years relative to the costs and benefits in earlier years.
So what is the basis for choosing the most appropriate discount rate for any particular environmental economics analysis? Generally, if there is a fairly well-known stream of annual costs, both capital and operating costs, for something like the water treatment plant noted above, most economists would argue for a discount rate equal to the interest rate at which the investing entity could borrow money. In this case it could be a town government, which might be able to borrow money at 2% in real euros. On the other hand, if the investment were being made by a for-profit corporation, the relevant interest rate, might be 4% real. Economists would typically suggest using the relevant interest rate for borrowing as the discount rate because then the annual stream of costs could be smoothed over time such that it really would not matter when the ups or downs of annual costs occurred. However, this argument is not really valid when considering how the annual environmental benefits should be compared to those in other years. Generally, environmental benefits, even if they can be fairly accurately quantified, which is often not the case, do not involve actual cash flows to the beneficiaries. Furthermore, the issue of what an appropriate discount rate is for comparing annual benefits for different years to each other is often more than a financial issue. For example, if the water treatment plant were forecast to save 100 human lives in its first year of operation, and 100 human lives in its fifth year of operation, how can we possibly compare the value of saving those human lives between those two different years of operation. For example, if we used a discount rate of 2%, which we shall call a public or social discount rate, because it is the rate of interest charged to government entities which build things in the social interest of the community, the value of the 100 human lives in the fifth year compared to those saved in the first year would only be about 92 (100 divided by 1.02 to the fourth power) equivalent human lives. But most people would quickly ask as to why human lives should be valued less in the future than in the present. Yes, why indeed?
The issue raised by this question is usually referred to as the “inter-generational equity” problem. Namely, the question is if we want to compare environmental costs and benefits across relevant generations of individuals (or across years), how should be do that in a morally reasonable way? Clearly, this issue becomes a moral issue, and not just a technical financial issue, because the relative importance of human lives are at stake in this type of environmental investment decision. The decision whether or not to investment in the water treatment plant, will, then, depend on whether or not the discounted benefits are project to exceed the discounted costs over the lifetime of the treatment plant. This is how many environmental economics problems are posed. Note that some environmentalists have argued that the only morally defensible discount rate to compare environment benefits over time is 0%, namely environmental benefits should be compared on an equal basis over time. This is how strict inter-generational equity could be achieved.
The same basic issue arises in considering when and to what degree to mitigate climate change. Of course, to mitigate climate change huge investments will have to be made in each year for the foreseeable future, and huge benefits to society will result in each subsequent year to society. So what, then, would be the typical consequences when considering investments to mitigate climate change if a low versus high discount rate is used to weight annual costs and benefits. For example, what difference would it typically make if the costs versus benefits of mitigating climate change were evaluated assuming a 2% real discount rate versus a 5% real discount rate, where the latter discount rate has usually been used in the integrated assessment economic models relied on by the IPCC in its economic evaluations of mitigation strategies and scenarios.
The main aspect of these IPCC evaluations that is very important for answering this question is the fact that they occur over a very long time period, often almost 100 years. (For example, from 2010 to 2100.) Thus, even if a 2% discount rate is used from a “social” perspective (and not a 0% discount rate), compared to a 5% “private investor” discount rate, after 50 years the difference in the weight given to the costs and benefits would be a factor of 4.4! Clearly, such a large differential weight would make a big difference in how 50-100 year streams of costs versus benefits for environmental investments like those that mitigate climate change would compare to each other in discounted euros. The net result of the use of a higher discount rate in making such an analysis is that environmental protection investments would tend to get delayed from the near term to the much more distant future, in order that the capital costs would be lower in discounted dollars. This tendency is precisely why IPCC analyses of climate change mitigation strategies show that it is typically most “cost effective” to delay mitigation investments in the early years when they are needed to keep global temperatures lower until later in time when they appear to be cheaper, because in discounted euros they are lower or “cheaper”.
When applied to what a cost effective investment strategy is prior to the year 2100 to mitigate climate change these considerations typically lead IAM model results to find that less investment in renewable electricity technologies is cost effective over the next few decades, and more investment in negative emissions technologies are justified in the subsequent decades just prior to 2100. The temperature impact of delaying mitigation investments in renewable energy technologies for this reason is that the global temperature will “overshoot” the target temperature increase set for 2100, which requires that negative emissions technologies, and not just zero-emissions technologies, get chosen for the decades just prior to 2100. Since almost all IAM-based scenarios were created by assuming a 5% real discount rate, leading to overshoot scenarios, the world needs to see what “cost effective” climate change mitigation scenarios would look like if a 2% social discount rate were used in the models, or even if a more ethical 0% discount rate were used.
Note that there is a vast literature on this subject. Additional suggested reading on these issues includes:
- Gollier, C. – Debating about the Discount Rate: The Basic Economic Ingredients, Perspektiven der Wirtschaftspolitik 2010 11(s1): 38-55.
- Goulder, L.H. and Williams, R.C. – The Choice of Discount Rate for Climate Change Policy Evaluation, Resources for the Future, RFF DP 12-43, September 2012.
- Roberts, D. – Discount rates: A boring thing you should know about (with otters!), Grist.org, September 24, 2012.
- Hodgkinson, D. – Thomas Piketty, climate change and discounting our future, The Conversation.com, August 11, 2014.
Also, see the numerous references that accompany these articles.