[Cross-posted with the blog for the conference Our Common Future Under Climate Change.]
Picture under CC-Licence 2.0 by Jason Baker.
When economically evaluating long-term policies, such as policies of climate mitigation and adaptation, the issue of how to weight future outcomes is of overwhelming importance in deciding which policies to adopt. The values that determine how to weight future generations strongly affect how governments decide on environmental policy and estimates of the costs of mitigation and adaptation.
A standard method, the cost-benefit analysis, which economists use to evaluate policies includes all the expected future costs and benefits of the policy as well as up-front costs (everything in this post about costs also applies to benefits). Economists discount future costs to generate present values for those costs. Then, since all the costs are in present terms, they can be added up to generate a net present value for the policy. If it is positive, the project is worth it. If not, the project is not.
Discounting in this context is very different from the usual (e.g. supermarket) use of the term. In this context, to discount means to remove an increasing percentage of the future costs as a function of the time at which they occur. This means that the effects that are distant in the future are multiplied by a smaller fraction (discount factor) than those that are in the future but sooner. The rate at which these discount factors grow is called the discount rate. With a positive discount rate, those costs and benefits that are expected to occur sooner are counted more in present terms than those in the future (with those in the present being undiscounted).
For instance, if we are considering mitigating by building a solar array, the up-front costs (which are counted fully as present costs) are quite high; the benefits (including potential reduction in climate change) accrue to the future. The benefits next year are weighted more heavily (they are multiplied by larger discount factors) than benefits the year afterwards and so on until those in dozens of years have very low present values (they are multiplied by smaller discount factors).
This might appear to be a technical academic discussion, but it has significant implications for the evaluation of long-term policies. Since many of the benefits of mitigation accrue to the distant future, small changes in discount rates have surprisingly large effects in evaluation of climate policies. This is the basis for a famous debate between Lord Nicholas Stern and William Nordhaus. The debate centered on the source of our moral or prescriptive values.
Stern holds that these values should be determined by reference to some particular expert group—Stern grounded some assignments in the moralists of the British utilitarian tradition. Nordhaus views these values as determined by social judgments—in particular, those as revealed through market activity. By making the social discount rate equal to a risk-free interest rate, one simultaneously endorses consumer sovereignty and makes climate policies theoretically cost-competitive with other projects.
I would argue that one reason that appeal to market rates is suspect is that significant pluralities—ranging from ~15%-35% (depending on the question and country)—reject anthropogenic climate change. To that extent, we would expect the public to have systematic biases away from saving for the future, with a distortionary effect on interest rates. Insofar as those who deny there is a problem cannot be excluded or extracted, it seems implausible to view these rates as good guides for policy evaluation.
This could be alleviated if there were fewer deniers, or if there was a systematic way to exclude them from the relevant datasets. It has even been argued that inconsistent or irrational preferences should still be honored by policymakers.
However, I think this consideration at least weighs against those who appeal to market rates, although there is, naturally, much more to be discussed.