On the Stern Review on the Economics of Climate Change and Discount Rates

Discounting the Future. By Indur M Goklany
Is it equitable to favor tomorrow’s wealthier generations over today’s poorer generations?
Cato "Regulation" - May 2009

[Full article at the link above]

One of the difficulties of analyzing climate change policies is that the costs of greenhouse gas emission reductions would be near-term while any benefits from those reductions would be delayed because of the inertia of the climate system.How should we compare costs and benefits that occur at different times? This, of course, isn.t a new problem. It is inherent to any investment that provides less than instant gratification, but it becomes a critical issue if an investment -and its associated benefits- are spread out over several years. It is precisely to deal with such problems that economists developed discounting.

Discounting recognizes that both individuals and societies prefer to get benefits sooner and to postpone any costs untillater. Discounting gives lesser weight to benefits and costs that occur in future years. Thus, for each year that eithercosts or benefits are delayed, their value is reduced by the annual discount rate.

Because this reduction is compounded, a benefit of $1 trillion obtained in the year 2100 would be valued much lower today. The higher the discount rate, the lower the present value of either costs or benefits occurring in the future. Thus a trillion-dollar benefit in the year 2100 would be valued today at only $1.2 billion if the annual discount rate is 7 percent, but at $52 billion if the discount rate is 3 percent.

Many people argue that if we value future generations. welfare, then we are ethically bound to employ a lower discount rate for future benefits that stem from global warming control policies enacted today. In contrast, use of a high discount rate for future benefits reduces the likelihood that carbon emission constraints today would pass a benefit-cost test, which, it is claimed, could put the welfare of future generations at risk. Some analysts such as Nicholas Stern, who conducted the Stern Review on the Economics of Climate Change, while emphasizing intergenerational equity, would use a near-zero discount rate (adjusted for the probability that a catastrophe might wipe out the human race and for the possibility that future generations may be wealthier than us). But the underlying premise behind using a low discount rate is that climate change, unless reduced sufficiently, could or would leave future generations worse off than current generations. This contrasts with the standard practice of using a market discount rate for both costs and benefits, so as to better consider the opportunity costs and avoid hurting both current and future generations by depriving them of the benefits flowing from current investments.

In this article, I address the threshold question of whether future generations would in fact be worse off than we are if climate change is allowed to occur and is uncontrolled. I compare current and future welfare per capita after accounting for the costs of climate change. To do this, I will reduce estimates of future welfare per capita in the absence of climate change by estimates of the welfare losses from climate change. For those downward adjustments, I use the Stern Review.s estimates of the costs of climate change from market effects, non-market (i.e., public health and environmental) effects, and the risk of catastrophe, even though several researchers have characterized the Stern Review.s estimates as excessive. I show that through 2200, at least, future generations will be much better off than present ones even after accounting for the costs of climate change.