We received this article as a rebuttal to our earlier post by David Middleton: “The Nobel Prize for Climate Catastrophe”… Seriously? ~ctm
Guest post by Mark Freeman
“’The Nobel Prize for Climate Catastrophe’… Seriously?” (WUWT, 21st December 2018) highlights the crucial role that the discount rate plays in determining optimal climate policy. Because of the compounding effects of interest over very long time periods, small changes in the discount rate can lead to very large differences in the present value of mitigation projects and therefore the economic case for pursuing them. $100 discounted at 5% for 100 years has a present value of only 76 cents. By contrast, using a 2% discount rate, the present value is almost twenty times higher at $13.80. Disagreement over the discount rate can be as significant as uncertainties about the natural sciences in the climate change debate – even if the latter dominates the former in press coverage on this issue.
In reference to the co-winner of the 2018 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, the earlier WUWT article states that “Dr. Nordhaus’ model suggests a ridiculously low discount rate of about 2.5%”. This critique is motivated by comparison with the rates of return offered by fixed income securities (“The minimum discount rate is currently usually 3%, about what you can get in US 30-yr Treasuries”) and other corporate rates (“In the oil & gas industry, we use a 10% discount rate when valuing proved reserves”). Using a higher discount rate would lead to a lower Social Cost of Carbon, meaning that fewer mitigation initiatives would receive policy support.
My co-authors and I have recently published (Drupp et al., 2018) the results of a survey of almost 200 economists who have expertise in intergenerational social discount rates (discount rates to be used by governments when, for example, determining climate change policy). From this we can conclude that, as far as most economists in the field are concerned, Nordhaus’ rate is too high and not too low.
First, it is important to note that the 2.5% rate that is attributed to Nordhaus in the earlier WUWT article is a growth-corrected discount rate, which “equals the discount rate on goods minus the growth rate of consumption” as given in the caption to the figure in that article. For a non-growth-corrected rate, Nordhaus recommends a much higher value. In a related article he states that “I assume that the rate of return relevant for discounting the costs and benefits of climate-sensitive investments and damages is 5% per year in the near term and 4.5% per year over the period to 2100” (Nordhaus 2014, p.280). Yet in our survey, the median response from our participants for the appropriate very long-term social discount rate is just 2%.
How can this be reconciled with the much higher rates offered by US Treasury bonds and the discount rates applied in the private sector? There are a number of rationales behind this.
First, it is important to distinguish between nominal and real rates of return. In the latter, inflation is stripped out and the discount rate is applied to cash flows estimated in $2019. In practice, nearly all governments apply real discount rates and Nordhaus follows this practice. By contrast, corporations in the private sector generally use nominal discount rates and then apply an estimated inflation rate to their expected cash flows – I suspect this is true of the 10% rate quoted from the oil and gas reserves sector in the earlier WUWT article. Treasury bond yields of 3% are also nominal; at present Treasury Inflation-Protected Security (TIPS) yields are considerably lower at about 1.2%.
Second, we need to consider whether we are using a risk-free or risk-adjusted discount rate. Corporations will generally adjust their discount rates upwards for risk. For social discounting, some countries also do this (notably France), while others, driven largely by the Arrow-Lind Principle, do not. Our median survey response of 2% is explicitly risk-free, comparable with the 1.2% yield offered by TIPS. Nordhaus’ 4.5% rate is risk-adjusted (“I assume that the consumption beta on climate investments is close to one” Nordhaus 2014, p.280) as would be the rate in the oil and gas reserves sector. It is important to make sure that, whatever approach we take to incorporating risk premiums into social discount rates, we are comparing like-with-like. Even ignoring risk, though, Nordhaus’ preferred discount rate remains above that of most economists we surveyed.
Third, one of the most heated debates within this literature is about whether financial market rates should influence the social discount rate. There are many who believe that markets provide the most appropriate indicator (this is called a “positive” or “descriptive” approach to social discounting). Others, though, believe that it is the government’s ethical duty to work out, from first principles, how discounting should be undertaken across generations rather than inferring this indirectly from the limited number of participants who influence market yields (the “normative” or “prescriptive” approach). This is because those in the future who will be affected by climate change, and those in poorer countries that are most at threat from rising sea levels, have no say over current US Treasury yields. International policy advice on this matter is mixed; for example, US government guidance is largely positive while UK guidance is largely normative. Our survey shows that economic experts are also divided on this matter, although most recommend putting greater weight on normative considerations. But whatever our own views on this, we must recognize that many believe it is unethical for international governments to purely outsource the determination of the social discount rate to US financial markets which are concerned with the current allocation of private capital and not matters of intergenerational and international fairness.
Fourth, there is a technical literature (e.g., Cropper et al., 2014) that argues that, all else being equal, real risk-free discount rates should decrease as the time horizon increases. This is a mathematical consequence (via Jensen’s inequality) when uncertainty increases over time. As climate change damages persist well beyond the maturity of the longest-lived Treasury security, this suggests that real risk-free intergenerational social discount rates should be below TIPS rates.
The earlier WUWT article cites the Office of Management and Budget (OMB) real social discount rate of 7%, but this is not the rate that the Interagency Working Group on the Social Cost of Carbon in the US recommends. “The interagency group ultimately chose three certainty-equivalent constant discount rates: 2.5 percent, 3 percent, and 5 percent per year. The two higher discount rates are principally informed by historically observed interest rates. The central value, 3 percent, is consistent with estimates in the economics literature as well as guidance from the OMB (2003) concerning the consumption rate of interest. Moreover, 3 percent roughly corresponds to the after-tax riskless interest rate. The upper value of 5 percent is included to represent the possibility that climate damages are positively correlated with market returns …The low value, 2.5 percent, is included to reflect the concern that interest rates are highly uncertain over time. Furthermore, a rate below the riskless rate would be justified if climate investments were negatively correlated with the overall market rate of return. The use of the low (2.5 percent) value is also consistent with certain prescriptive judgments and ethical objections that have been raised about higher discount rates” (Greenstone et al., 2013, p.34).
There is one other important point to raise about the earlier WUWT article, which was particularly scathing about the proposed use of a 0% discount rate. To understand this, it is necessary to distinguish between the utility discounting of, for example, health and life itself, and the consumption discounting of future income streams. The discussion above and the original WUWT article are concerned with consumption discounting. In this case, only a small minority of our survey respondents believe that a 0% discount rate is appropriate. But for utility discounting, the most common response from our experts was a rate of 0%. This is because many believe that the intrinsic worth of life itself should not be discounted. So, when the earlier WUWT article states that “A discount rate has nothing to do with the value of ‘future generations’ versus ‘nearer generations’” this is not strictly true. Such considerations are central to determining utility discount rates and, within a normative setting, these form a component of consumption discount rates.
For those with further interest in these issues, my colleagues and I have recently co-authored reports for HM Treasury (Freeman et al., 2018) and the Office for National Statistics (Freeman & Groom, 2016; Freeman et al., 2017) in the UK, where more detailed discussions are given. Getting to some consensus on these issues, as well as on the scale of climate threats themselves, is absolutely crucial if we are ever to reach agreement on climate change mitigation policy.
Mark Freeman is Dean of The York Management School, University of York, UK, where he is also a Professor of Finance.
References
Cropper, M.L., M.C. Freeman, B. Groom and W.A. Pizer (2014), “Declining discount rates”, American Economic Review (Papers and Proceedings), 104(5), 538–543.
Drupp, M.A., M.C. Freeman, B. Groom and F. Nesje (2018), “Discounting disentangled”, American Economic Journal: Economic Policy. 10(4), 109-134.
Freeman, M.C. and B. Groom (2016), “Discounting for Environmental Accounts”, Available on the Office for National Statistics website: https://www.ons.gov.uk/economy/nationalaccounts/uksectoraccounts/methodologies/naturalcapital
Freeman, M.C., I. Clacher, K. Claxton, and B. Groom (2017). “Reviewing Discount Rates in ONS Valuations”. Available on the Office of National Statistics website: https://www.ons.gov.uk/economy/economicoutputandproductivity/output/articles/reviewingdiscountratesinonsvaluations/2018-07-11
Freeman, M.C., B. Groom and M. Spackman (2018), “Social Discount Rates for Cost-Benefit Analysis: A Report for HM Treasury”. Available on HM Treasury’s ‘Green Book’ website: https://www.gov.uk/government/publications/the-green-book-appraisal-and-evaluation-in-central-governent
Greenstone M., E. Kopits and A. Wolverton (2013), “Developing a Social Cost of Carbon for US regulatory analysis: A methodology and interpretation”, Review of Environmental Economics and Policy, 7(1), 23–46.
Nordhaus, W. (2014), “Estimates of the Social Cost of Carbon: Concepts and results from the DICE-2013R model and alternative approaches,” Journal of the Association of Environmental and Resource Economists, 1(1/2), 273-312.
Discover more from Watts Up With That?
Subscribe to get the latest posts sent to your email.
All the mental masturbation over the various costs of Climate Change only end up supporting the false narrative that is the basis of the hysteria.
Agree. There are NO benefits from responding to imaginary threats, only costs.
@beng135
“There are NO benefits from responding to imaginary threats, only costs.”
I would clarify further…if part of the “argument” is that we need sustainable energy to address limited resources, then it follows that chasing after a false problem with valuable, limited resources (money, time, manpower) is a waste of those resources. With $22trillion in debt, an internationally shaky market, and a false problem, we make matters far worse. It’s just trading one resource problem for another.
The argument is the same for those who wish to curb CO2 emissions and force renewables down our throats for the reason, “just to be on the safe side”. Again, we’re chasing after an imaginary threat/wrong problem which simply wastes limited resources, doesn’t solve the problem, and channels those limited resources away from solving real problems instead.
Yes indeed…
Prominent climate change expert arrested for beating, strangling wife.
http://m.startribune.com/university-of-minnesota-professor-charged-with-domestic-assault/503586522/
@John. That has nothing to do with the subject. You are using the Poisoning the Well Fallacy. i.e. climate change expert is arrested for beating his wife therefore what he says is invalid.
His arguments are invalid for many reasons, but you don’t need to use illogic to try to prove it.
+1
I agree Mark and Beng.
What is the appropriate discount rate for (at best) extreme incompetence?
Spot On, markl and beng135!
Estimating the costs of something 80 plus years out is a rather futile exercise at best, and destructive at worst.
Pointing out that fairly small changes in the discount rate radically affect the outcome of any “social cost of carbon” formulations only demonstrates just how useless the exercise is.
That is the problem the interest rate etc are a few percent but the entire economy will look different in any 80 year period.
Perhaps the challenge first is for anyone to show us a method hat works over 100 years or more in a hindcast. That would at least cover several historic period of economic change and even it gives no guarantee that future technology changes might not be more radical.
This whole SCC thing is predicated on the assumption that higher CO2 in the atmosphere has a net negative effect going forward. And that is predicated on the theory that increased CO2 will increase the “global average” temperature by 1 or 2 degrees which will in turn cause catastrophic results. That’s a bit of a house of cards, if you ask me. But let’s say, for the sake of argument, that increased CO2 will cause the temperature increases that are claimed; it’s still by no means certain that the effect will be negative. In fact, since we are currently in the middle of an ICE AGE, I would argue that it can only be net beneficial since any such warming can only be temporary. The natural cycles which cause the ice sheets to grow over much of the planet will overwhelm this CO2 effect and will plunge us back into a glaciation period that will last many thousands of years. It’s only a matter of time, and probably not as much as everybody would like to think.
The only rational course of action is enjoy the warmth while it is here and advance our technology as fast as possible – it will be the only chance we have of surviving.
Nordhaus may be a tad high, but it is an honest attempt at the appropriate relative valuation across generations. Nicholas Stern (of the Stern Review) uses a ridiculously low 0.1%, which necessarily cooks the books in favor of “climate action”.
https://www.nytimes.com/2006/12/14/business/14scene.html
Prof. Freeman is entirely correct that terms should be carefully and rigorously defined. The many papers in this field often use different terms to produce more dire predictions, all the while entirely ignoring the benefits we have had from fossil fuel use and CO2 production.
The whole “intergenerational” argument really confuses me. A new generation is born every day. The “social discount” costs are equally ephemeral. The scientific progress we see almost every day cannot be predicted and neither can unknown results from unknown discoveries. Like the weather, the best economic predictor is “tomorrow will be much like today, except when it isn’t”.
Another prediction problem is that the possible range of results increases dramatically with time. Any study purporting to predict should be primarily a discussion of the sources of variability and error and how they compound very quickly.
There are also major problems with the definition of “social cost of carbon” that make the term wholly unscientific and non-economic. Using cute elisons in any scientific paper should make it unpublishable.
I like how Dr. Freeman has put this discussion together – comprehensive & well written. Thanks for your contribution to this site!
My main issue is that we are looking at risk free discount rate ( ie beta=1). The risk here should be that the climate models are not correct/ overstating climate sensitivity, in which case we are allocating resources to a problem that either doesn’t exist or isn’t a big enough problem to justify the investment.
How big is that risk & what should a risk adjusted discount rate be? I’ll leave that to the thread to discuss.
The other risk I forgot to include is that the capital allocated for some mitigation measure has a meaningful impact, again which will be model-driven. This is no different than and oil & gas exploration company risking capital on a wildcat well because the outcome is uncertain, just as it would be with any mitigation measure.
At least with a well, you spend some money and you go and drill the site. You test the hypothesis before you set up a full extraction platform, processing plant, and oil line to the nearest port.
With Climate Change, you just jump in the deep end, and go the whole hog up front with complete disregard to weather the science/models are correct or not. It’s a faith based belief in full.
+1
“….with complete disregard to weather the science/models are correct or not”.
Nice pun Greg!
Whether the weather be fine or whether the weather be not, we’ll weather the weather whatever the weather, whether we like it or not!
Cheers
Mike
Yea, that “whether” has never stuck with me. I keep forgetting that it exists or if I do, how to spell it.
The difference is that the risk exposure to a wildcat well is finite over a short duration.
If the prospect has a 50% chance of geological success, the decision to drill is based on 50% of the p50 resource potential. If it’s a duster, you P&A it, write off as much as you can and move on.
My problem with this paper is the source of the data he uses.
Who exactly gets to determine who is and who is not an “expert” in discount rates for use in determining government programs???
I think I can answer that: Prof. Freeman only considers those people who agree to a low-enough discount rate to justify proposed government intervention as having sufficient intelligence to demonstrate expert-status.
That’s easy.
Anyone with a dartboard and a dart.
It’s his paper, so he’s allowed to chose which experts he quotes. If you don’t like them, say why and tell us who is a more appropriate expert and why.
We talk about this quite a bit in the paper. “Experts” are those who have published on social discount rates in good academic journals in the field. There are two main reasons choosing this sample. First, governments generally get advice from “experts” about economic matters – look at monetary policy committee membership, for example. So understanding the views of those with professional expertise is important as it is most likely to influence policy. Second, we wanted to “disentangle” the responses into their component parts. These are well understood to economists (for example, the rate of societal pure time preference and the elasticity of marginal utility) but difficult to quickly explain to a wider audience in the time they are likely to devote to responding to a survey. But my co-authors and I would love to run this survey across a wider, more democratic, sample as well as on a different sample of “experts”: Wall St / City investors. But working out how to ask the questions is really not straight forward if you need to get meaningful answers quickly (and neither is getting sufficient access to expertise within financial institutions).
I think that it would be a great idea to sample economists and accounting professionals in the private sector too.
Yes
Because Government Monetary Policy ‘experts’ have such a fabulous record of making brilliant recommendations !
/sarc.
OK, so let’s look at the factors mentioned.
1. Discounting ‘life’: The money used (wasted?) on mitigation will diminish the well-being of future generations. For marginal peoples, this may cause earlier death, greater child mortality, etc. By saying that 0% should be used, Freedman suggests that life only will improve if we spend the money, which is bogus. Let’s say that ‘life’ will be only 1% less livable.
2. Growth: to the extent that money is diverted from positive economic uses, then growth will be reduced. This suggests that the discount rate ought to be higher, not lower. Again, let’s low-ball the reduction of growth and call it 1%.
3. Inflation: If we assume a zero discount rate, then just considering that the money returned has less purchasing power than the money used forces a positive discount rate. Stripping out inflation is stupid, or at least incompetent. Unless the FED and other central banks are abolished (fat chance) and Gold or some other inflation eliminating method used, inflation must be included, not excluded, from the discount rate. As the Dollar has been debased during the last 100 years by 100 times (10,000%), that implies an inflation component in the 4-6% range going forward is reasonable. Let’s say 4%.
4. Basic discount rate: Rational people may forego current consumption if there is ‘something in it for them.’ Very few people would lend their money at 0%, while many more would do so at 10%. What is the market clearing rate for the vast sums needed for mitigation? Seeing 30 year Treasuries over 3% and rising would seem to imply at least 3% and likely over 4% for a discount rate factor. Let’s assume 4%.
Putting all these together (estimates), 4% base rate, plus 4% inflation, plus 1% lowered growth, plus 1% negative effect on human well being due to mal-investments implied, yields a 10% discount rate, considerably higher than the 7% rate generally used in US government analyses.
“Getting to some consensus on these issues, as well as on the scale of climate threats themselves, is absolutely crucial if we are ever to reach agreement on climate change mitigation policy.”
Great column. I would say there is a lot more divergence of opinion on what is the scale of the preventable threat from climate changes than there will ever be on discount rates. But for now I would consider it a win to convince everyone that spending $1 today to save $1 in 20, 30, 50, or 100 years would be idiocy.
I’ve found in the corporate world that even sophisticated financial models generally apply a discount rate that includes a risk premium even after risk-adjusting the future cash flows. In these cases, they theoretically should be using a risk-free rate. However, because of the existence of biases that remain in the forecasts the rates applied are not actually inappropriate as one mistake offsets the other!
The other point to make is that risk does not apply to all cash flows equally. For example, we might contract for a lease that has regular payments over time in order to earn a revenue stream. Typically, the incoming revenue stream will be a lot riskier that the outgoing payment stream. Theoretically, that means that we should apply different risk adjustments to each cash flow stream. Nobody ever does though.
These income streams and outgoings are also modified by tax deductability.
So the utility varies as the deductability/subsidy varies, which varies between individuals.
Since these may turn on a pin at any time, depending on soverign wealth and popular fiat,
it must be very courageous to try and forcast a discount rate beyond the forseeable future for whole populations.
With economics it is usefull to provide orders of accuracy with predictions/projections.
With a spread of 0 to 4.5% plus or minus some error,everyone could be right, until proven otherwise.
the intrinsic worth of life itself should not be discounted.
====
That is nonsense. Mother Nature discounts the worth of human life over time.
How much would your 80 year old average human being be willing to pay to be 20 years old once again? How much would your average 20 year old be willing to accept in return for being 80 years old?
Interest rates are today historically low. Very low. They have been very much higher in the past. As such, one should error on the side of caution and select a higher discount rate rather than a lower rate.
Any sane 80 year old would pay every cent he or she has, or could beg, borrow or steal, to be 20 again.
No sane 20 year old would accept any amount to be 80.
I am curious if others see it the same as me.
On that basis you need to go for the lower rate because most developed nations have aging populations who you can kill for next to nothing … just saying 🙂
This new ocean heat paper does the round, free access, not pay-walled…
http://science.sciencemag.org/content/sci/363/6422/70.full.pdf
Easily done, if one accepts that economists, like climate scientists, have a tendency to talk from where the sun don’t shine. When did they ever predict anything of the future beyond the next Fed rate change (and it’s not like they are very good at the timing and amounts of that, once one considers that the Fed makes sure that banks have inside knowledge)?
And how many industries, including fossil-fuel extraction, would have vastly different future profit/loss potential in the absence of government taxation/regulation?
Since the advent of global-warming alarmism we now have at least two “dismal sciences”.
I have seen statistics showing that weather forecasters have a higher percentage of correct forecasts (in the range of their forecasts <1week) than economists. And you know what problems they have. I am constantly seeing predictions that we are on the verge of a total collapse of the economy and also predictions that we are on the verge of heaven on earth. Economics is the "science" of trying to predict how humanity is going to behave. Heck, there are times in which I can't even explain to myself why I do things, how is some expert supposed to figure out what people are going to be doing with their purchases even a year from now? There are way too many variables.
Government economists are united in supporting a position that encourages more government programs.
What a surprise.
Many thanks to Prof Freeman for contributing, and to WUWT for publishing, a very clear and detailed explanation of the issues in choosing a discount rate for climate issues.
Many of us are very familiar with the traditional NPV valuations done in corporate life to evaluate the merits of projects, but as this very informative piece makes clear, the issue of picking the right discount rate on long lived social projects is different and much more complicated.
I agree with other commenters that the discount rate is probably the least of the problems when it comes to 100 year forecasts and preventive measures. The real issues are the likelihood of the forecast disasters, the costs of averting them, the effectiveness of the measures proposed, and the opportunity costs of investing in them.
Nevertheless, this piece was welcome and instructive on the issue that it touches, so many thanks. Greatly appreciated. Its willingness to publish this kind of posting, and the fact that people like Prof Freeman are willing to contribute them, that makes WUWT unusual and special in the climate field. Genuinely informative material and genuinely open discussions. Very rare.
When choosing a discount rate, I think that the critical issue is this one: “the opportunity costs of investing in [preventive measures]”
Ultimately, discounting is meant to reflect the fact that investments in one project could instead be made in another project of comparable risk. This applies to investments made by governments no less than investments made by private firms.
Note also that the rate of return on government bonds has nothing to do with the risk of the projects that governments invest in. The same rate would apply even if all the funds are used for current spending on transfer payments — not investments at all. The rate on government bonds instead reflects investor expectations about future politicians’ willingness to use the power of compulsory taxation to pay off the debt with the promised interest.
In the final paragraph I meant to say the risk premiums in the rate of return on government bonds (eg the differences in rates between different countries) has nothing to do with the risks of the projects that governments invest in (contrary to the case for private firms).
The the rate of return on government bonds has a lot to do with evaluating the economic impact of regulations on businesses and other entities who have to pay for those regulations.
The OMB guidance is for a 7% discount rate…
https://www.transportation.gov/sites/dot.gov/files/docs/OMB%20Circular%20No.%20A-4.pdf
3% is about what you can get with long-term government bonds.
The “benefits” of a regulation should be able to withstand the cost to the private sector of those regulations… Otherwise, there are no benefits… Not even speculative benefits.
What the heck is a discount rate? Here’s a definition.
If I understand correctly, the lower the discount rate, the worse the investment.
So, doesn’t that mean that spending money now on climate mitigation is a lousy investment? What am I missing? It sounds like some folks think the discount rate should be a lot higher.
The discount rate is a bit like interest. The best reading on the subject generally is Brealy and Myers, Corporate Finance.
To explain it, suppose someone offers you 100,000 for something – a bit of land, for instance. This is the amount he will pay you today if you strike a deal.
Someone else comes up before the deal closes and says he will pay you 130,000, but he will close in 5 years time. Lets suppose you are totally certain that he is good for it, so risk doesn’t enter in.
Which is the better deal?
To find out, you have to decide what the present value is of his 130k offer. What is the price an informed investor should pay now, to get that 130k in five years?
To find this out, you need to discount the 130k. You are basically giving him a loan. But instead of it being a fixed loan now, and you then use interest rate to tell you how much you want him to repay, you are taking the future payment and the interest rate, which is in this context called a discount rate, to tell you how much this promise is worth in today’s money. This amount is called the present value.
So the quantity of the discount rate does not bear on how good an investment it is, in itself. What it does is, tell you how much the future cash flows from that investment are worth in today’s money.
Now the reason for the debates will be clear. if you set the interest rate, the discount rate, very low, that means that future cash flows have higher present value. If very high, then future cash flows will have lower present value.
The same calculation and the same arguments occur in the UK with leasehold extensions. How much should a buyer pay for extending the lease? Well, one factor is the discount rate. Make it higher, and he should pay less, because the future flows are worth less in today’s money.
Hope this helps. Read Brealy and Myers for a full and surprisingly readable account. Or fire up a spreadsheet (LibreOffice will do fine) and play with the NPV formula.
The lower the discount rate, the safer the investment. In a corporate setting it is used in net present value analysis to help you determine whether it is worth making an investment or not.
If you have an absolute sure thing investment that cannot fail it should be discounted using the risk free rate. This is the rate of return a completely risk averse investor requires in order for to forgo using their dollar today and invest it instead. The US treasury is generally recognized as the safest investment in the world, and thus is used as a proxy for the risk free rate.
In the business world, any investment you make should be expected to exceed this rate of return.
The article above is pretty good at explaining how different people come up with the discount rates for a social/inter generational program. There’s not a mathematically right answer for this. Within a certain range of values (say 0-6%) it really comes down to your perspective on how policy should be made, the lower the rate you have the more pro-social your point of view and the higher the rate the more pro-business your point of view.
This is why there is such a difference in how different groups value this discount rate and the benefit value of programs. I would also argue this is also not where the main disagreement lies. More important than the discount rate is really how you value the future costs related to not addressing warming. If you assign no benefit to mitigation or you believe that not mitigating in its own right is long term beneficial, it doesn’t matter what you’re discount rate is. There is never a return on your investment if you choose to mitigate, social or otherwise.
Thank you for this high quality and thoughtful article. Economists seem to look only for unlikely costs with which they can beat us over the head. As a consequence this loading of the dice on money that ‘needs’ to be spent on ‘climate change’ ( in its broadest sense) will result in a number of serious repercussions for the west.
For example power that has become much too expensive for ordinary people and many businesses (such as Tata steel) The windmills and solar panels etc become hugely expensive (even at cleverly calculated discounted rates) when they barely work and last a much shorter time than envisaged.
The costs that HMG are busy calculating also need to take into account the actual amount of ‘mitigation’ achieved. Assuming we are responsible in the first place for change, once co2 has been emitted its effects means spending hundreds of billions of dollars in order to achieve any sort of temperature reductions. The costs to reduce global temperatures by tenths of a degree can not be economic, however the rates are worked out.
Thirdly, lets not forget that the largest emitter on the planet-China-is being given a free ride. In fact not even ‘free’ in as much we are supposed to pay them!
When all is said and done, on any balance sheet there is a profit AND loss column. The Wests use of fossil fuel (and lets not forget Britain’s leading role in the industrial revolution) has meant people are healthier, wealthier, better clothed, better housed, live longer, have the rule of law and democracy and enjoy life in a way our forefathers could not even have dreamt of.
Why are these tangible benefits not actually costed in the plus side of the balance sheet?
The enormous benefits seem to have been forgotten in our mad scramble to blame everything on us and unrealistic costs attached to it. Why not redress the balance and it may be found that what we have achieved over the past couple of centuries has been a wonderful boom to humanity and has been highly cost effective.
tonyb
Why are these tangible benefits not actually costed
============
Agreed. The benefits are ignored to create a false narrative.
consider penicillin:
Penicillin has been a huge benefit, but it has also killed a number of people prematurely. What is the social cost of penicillin? Should we create a penicillin tax to reduce the use of penicillin? Should China be able to use penicillin freely, while the US pays them?
This same approach applies to EVERYTHING. There is no such thing as a product that only has benefits without any side effects. Even water. Water kills many, many people every year. Should we have a Water Tax on the social cost of water?
So a tax on the product raises the value of the product reducing the use of the product. Is this a risk mitigation method?
It is exactly what the Australian government has done to cigarettes, which are now $27 per packet (average). When the tax on cigarettes was first introduced they were about $12 per packet, upping that value by 50% did nothing to stop the smokers, it was still affordable. Only now is a packet so expensive that very few people can afford to smoke.
What is most interesting with cigarettes, is that they are still available. They havn’t been banned. So was this truly a health decision?
When the tax on cigarettes was first introduced they were about $12 per packet, upping that value by 50% did nothing to stop the smokers, it was still affordable. Only now is a packet so expensive that very few people can afford to smoke.
If you price a product beyond peoples means to buy it, then less of that product will be sold.
My father was a smoker most of his life. He suddenly quit once he considered cigarettes more expensive then they were worth to him.
What is most interesting with cigarettes, is that they are still available. They havn’t been banned. So was this truly a health decision?
Not healthy for those that can still afford them to be sure. Not economically healthy for those who can’t really afford them but still buy them anyway. Healthy for those who can’t afford them and thus don’t consume them anymore. But Healthy is the wrong question, as the cigarette tax was never about health but about a source of revenue that government can tap without much blowback from the masses. There will never be “yellow vest” (“yellow teeth”?) riots over cigarette taxes because everyone knows that cigarettes are not healthy for you and so can’t get that worked up over a tax that makes it more difficult for people to afford them. That’s why governments love “sin” taxes – the masses don’t want to be seen protesting for “sin” so will let massive taxation go where they wouldn’t stand for it in other circumstances.
Last para spot on. When doing NPV assessments, the first thing you have to do is make sure you have, for each alternative under consideration, all the cash flows, positive and negative.
Then, when doing the calculation, the question is comparison. Its not just is this positive or negative NPV.
Its whether this particular course is generating greater cash returns than other possible courses. Which is why the measure has to be NPV, cash, rather than IRR.
It has been remarked that Climate Scientists fail to engage expert statisticians and so stumble into the kind of errors that Mann and associates fell into.
But its also true that they fail to engage expert finance people and so fail to make any case they may have to the standard expected by any Fortune 500 Finance Committee.
Attempting to calculate the value of a future event the way it is typically done in economics is mostly nonsense.
Will interest rates be higher or lower in 5 years? No economist can answer that question with any greater skill than a dart board. Yet they insist we can calculate effects 80 years in the future.
Should you buy an air-conditioner, or should you contribute the money to a global scheme to reduce carbon? Anyone with an ounce of sense knows that international bodies have an extremely low rate of success, especially when the economics are against them. So the safe money would buy an air-conditioner.
This what economists fail to take into account. You are 100% certain to succeed if you buy the air-conditioner, while the international governments are 0% certain to succeed if you give them your air-conditioner money.
The BIG problem neither post touches on is the discount rate time horizon. Anything more than about 30-40 years means discounting methodology should not be used at all. There are two reasons.
1. Too sensitive to small rate differences, as noted.
2. More importantly, the uncertainties in the ‘world’ being discounted are far too large for any result to be meaningful. This is true in spades for ‘climate’. Some examples:
a. Any long term discount rate applied to oil reserve values before the shale fracking revolution produced an essentially meaningless result.
b. Any long term discount rate applied to any telecomm investment before the cellphone/internet revolution enabled by Moore’s law produced a meaningless result.
The same is true for most circumstances. I wrote a major paper for a large multinational client showing that they should not (in their industries which included electrical and medical equipment) discount out further than about 15 years bcause of the provable rates of technical change that eventually undercut all the economic assumptions being discounted. Put differently, if they could not get their money back with the required CAPM return in less than 15 years, they should not make the investment, period.
1. Too sensitive to small rate differences, as noted.
==========
Also, the sensitivity increases over time. It does not converge no matter how far you look into the future.
This is contrary to what we expect intuitively. We expect heads and tails to balance out over time, but discounting does not.
As a result, the confidence level one can apply to a discounted future value quickly approaches zero the further you go into the future.
As such, even 1 year plans are hard to achieve, and 5 year plans rarely go as planned.
Wow, sounds a lot like weather forecasting. Climate scientists have no clue, and economists even less.
Yes, agreed. The main problem is not at what level you discount it, though the discussions reported in the post on that subject are very interesting.
The main policy problem in climate is getting something meaningful and certain enough to apply the discounting to. And yes, the length of time of the horizon is a key factor in this.
This is how we get to the ‘Precautionary Principle, aka Pascal’s Wager 2.0….
Thanks Rud, clear and concise as always. It reminded my of roof top solar. The investment return must be within a practical time period or it’s a wasted effort. Add maintenance and replacement to solar and the investment becomes even more difficult to justify.
Future technologies makes guessing discount rates outside of 10 years a fools game.
It seems you don’t really mean that they shouldn’t discount, rather that they should discount 100% (or just consider the future value unknowable).
Proved reserves are the minimum volume of oil a reservoir is expected to produce. This is generally a >90% probability number.
When an oil company buys proved reserves from another oil company, the purchase price is based on the future cash flow value of their proved reserves. A discount rate compensates for the time-value of money. If the future cash flow from Oil Field A’s proved reserves is $100 million. You would lose money, if you paid $100 million for those reserves and that’s all that was produced. You could have put the $100 million into 30-yr Treasuries and made money. That’s why the future cash flow is discounted using a 10% rate. The purpose of the transaction is to make significantly more money than you could make from 30-yr Treasuries.
That said, if Oil Company B was acquiring Oil Company A, the purchase price would be based on the PV10 value of the proved reserves plus whatever value they placed on Company A’s resource potential (un-drilled prospects, up-side opportunities in existing fields, acreage position, etc.) But, ultimately all of that would be valued on a risked basis and discounted to come up with a purchase offering price.
And the difference being off course when talking about oil companies that it not all made up bullshit, like crap the in this article which is mostly social cost none sense.
This is not correct…
Reserves don’t work that way.
Proved reserves that are being added due to frac’ing and horizontal wells in shale and tight rock plays weren’t reserves of any kind prior to the shale frac’ing revolution. They were potential resources, which are not booked or factored into PV10 analyses.
PV10 is the future value of cash flow from existing proved reserves using a 10% discount rate. This is basically what companies will be willing to pay for proved reserves.
David,
Do you then neglect resources completely in your PV10 calculation?
Historically, I always have, but recently there seems to be a trend toward using ‘Value Beyond Proven and Probable’ (VBPP). This approach applies a probability factor of .75 for Measured, .50 for Indicated and .25 for Inferred Resources.
You can value them. They’re just not something you can book as reserves.
As you noted, they have to be evaluated on a risked basis. When we look at possible acquisitions, we definitely try to ascribe a value to resource potential. But, it’s just a potential premium we might offer over and above the PV10 value of the proved reserves. But, you have to be careful about carrying value of undeveloped acreage on the books. If that acreage is never developed, as often happens, and the leases expire, you have to take a write-down,
David, true enough, but I think his point was a field that was just under the wire to exploit just before that first “slippery-frac”, if it didn’t start drilling then it’s not going to start now, because the price those products could bring aren’t high enough today to make it worthwhile to even start. Unless additional data has shown that field may be easier (cheaper) to exploit than first thought.
That’s totally unrelated to proved reserves. Proved reserves have a specific legal definition. If we were evaluating a field where a new technique might increase the proved reserves, we might be willing to pay a premium over the PV10 value to buy the field. However, proved reserves cannot be based on technology that might be just over the horizon. Nor can they be based on expectations of higher oil prices.
If it’s a field with proved reserves, it’s already being exploited. That’s the only way resources can become reserves.
That’s why you can’t generally get a bond for more than 30 years.
DCF & NPV are scientific and accurate method of evaluating estimates of future cash flows and choose between investment opportunities.
Therein lies the rub – the problem will always lie with the estimates including your discount factor.
As I used to tell my students – it will give you the wrong answer to 16 decimal places.
But, if you are not discounting more than 15 years out, Rud, then you are discounting to the project end but applying an infinite discount rate beyond year 15. There is no problem with this, but it is still a discounting choice. Any decision to forego consumption today to get (potential, risky) benefits in the future is a discounting problem. And decisions that you make to accept / reject projects will, over time, reveal a discount rate for you even if you have not explicitly stated it. The view of most governments is that it is better to explicitly estimate a long-term discount rate, despite the many problems this entails, rather than making decisions that implicitly involve a discount rate but not stating what that is.
Bingo!
It is a long time since I did this stuff, but when I did do so I formed the opinion the discount rate is a lousy place to build in risk, build in uncertainty.
There is no doubt there is a social discount rate. There is no doubt people are willing to spend money for future returns, but want those returns to be somewhat more than the returns from an immediate gratification. Thus, I thank Mark Freeman for contributing this article, and thank WUWT for posting it.
Having said that, the challenge with the climate change debate is the “if … may … could … ” formulation that creates a hazard with a low probability of occurring. My preference is to do the best job possible of reflecting the true societal view of the future value of investments, and completely separate from that do a meaningful job of presenting the range of outcomes, and weighting the future benefits accordingly.
Judith Curry has done an excellent job of keeping the uncertainty visible. Baking the uncertainty into the discount rate is a bad idea, undermining her efforts.
Excellent!
Comment on the Arrow-Lind Theorem from a book on project evaluation “Applied Welfare Economics” by Chris Jones (Oxford U Press)
“Ultimately, support for using a lower risk premium in the evaluation of public sector projects [relative to the risks inherent in the uncertain costs and payoffs] must rely on some form of failure in the private market for spreading and diversifying risk. Either private risk pooling is more costly than it is for the public sector or the public sector has better information.”
Are those conditions likely to be true?
Yes, I agree that applying the Arrow-Lind theorem to climate mitigation policy is problematic. But if you don’t, then you need to start estimating the risk premium as well as the risk-free rate. This introduces yet more room for disagreement. Nevertheless, governments should, in my opinion, do their best to do this, and many are now starting to do so.
With an 80 year horizon, do you have any confidence that the discount rate you arrive at will be any more accurate, or provide any more confidence, than the proverbial monkey throwing darts at a dart board? If this isn’t a truly mathematical computation, i.e. governments deciding such rates rather than markets, how do you eliminate bias? It seems to me too easy for a desired policy to determine the rate, rather than the rate determining the desired policy. What about discounting out about 15 years, which by then, according to the latest Assessment report, should be showing a definite trend in temperature increases?
“Fourth, there is a technical literature (e.g., Cropper et al., 2014) that argues that, all else being equal, real risk-free discount rates should decrease as the time horizon increases. This is a mathematical consequence (via Jensen’s inequality) when uncertainty increases over time.”
The fact that uncertainty increases with time cuts both ways, one could just as easily argue that discount rates should increase because of the uncertainty as to how much good the expenditure will do in the future. Does it make sense to spend money now on something that has only a low possibility of benefiting future generations?
“But for utility discounting, the most common response from our experts was a rate of 0%. This is because many believe that the intrinsic worth of life itself should not be discounted. So, when the earlier WUWT article states that “A discount rate has nothing to do with the value of ‘future generations’ versus ‘nearer generations’” this is not strictly true.”
WUWT was correct the first time, spending money on current problems will benefit future generations, e.g. improved agriculture will cut starvation now and in the future. Conversely spending money on CO2 reduction will harm people now and may harm others in the future.
For a more balanced assessment, the social cost of carbon should be weighted against the social cost of renewables, the environmental cost of renewables, and the social cost of socialism.
At the very least a side by side comparison made by the same person would be illuminating.
I believe the same person do both analysis, otherwise it’s a tit-for-tat argument and neither side will give ground. In the end, no progress is made.
I agree. Finding a neutral unbiased person to do the analysis would be paramount – someone not on the payroll of any government, special interest, or industry if that’s possible.
So in the end it comes down to the Precautionary Principle.
The faith-based belief that climate change will be so catastrophic that spending money on clean water today, instead of windfarms, would save fewer lives. Ridiculous.
If it’s that bad then the numbers don’t really matter.
The belief is in Hell unless you Repent and Obey the Climate Religion.
It’s counterintuitive to me that the discount rate should be *reduced* by future uncertainity. That fact that climate policies have immediate, predictable negative costs while producing uncertain, far off supposed benefits seems like an excellent reason to *discount* the alleged benefits, not value them equally.
The idea that intergenerational costs should be biased low also seems to fit poorly with an expanding economy. Suppose that there was some was some policy that if taken (at some cost) by the US in 1967 would have made the US per capita adjusted-inflation income 1% higher. So instead of 55,767.46 in 2009 dollars, we would instead be at 56325.13 — those selfish people in ’67 cost us $557.67 each. Using a discount rate of 0%, they should have been willing to spend $500 to save us $557, right?
But the per capita income then was $23,132.47 even with their selfishness, and asking them to sacrifice over 2% of their income so that their *twice as rich* descendants would be a further 1% richer doesn’t strike me as “fair” at all, even if the impact analysis were rock-solid.
Of course, with the approximately 1C warming that has happened since not-really-pre-industrial times, it appears the warming+CO2 fertilization has been a net *benefit* — and the cost of leaving the evil fossil fuels in the ground would be aborting the very industrial revolution that has made those of us in developed nations so comparatively wealthy and largely immune to climate. Still developing nations can benefit *so much* from industrialization that even if they did it with 100% coal the world would obviously come out way ahead.
What kills people isn’t climate, it’s poverty. That’s by far the largest risk factor.
Let’s consider sea level rise. A 100 year old house by the sea may have a market value of $200,000. It was probably built for say $500,maybe less. The cost to rebuild it now is say $100,000. When it was first built automation was minimal and hand building predominated. Now say it gets washed away and $100,000 has to be spent to rebuild it inland. In real terms $100,000 now is far less than the original $500 because of efficiencies and inflation. Consider 20 new cars each costing $10,000 each,valur $200,000, in 20 years they will all need to be replaced. Clearly car building and ownership is far more dangerous than climate change.
In any city those properties that have a water/ocean frontage are generally the most expensive lots to buy and live on.
That means the current efforts to reduce sea level rise is a transfer of wealth from the population as a whole to those that are already wealthy enough to have a ocean frontage.
Seem’s like the Left has got it wrong if the ideal is to transfer wealth from the rich to the poor.
Seems like it would be easy to look at what the discount rate should have been if people had engaged in climate mitigation funding in 1940. After all, we should have seen the effects of climate change over these past 80 years. CO2 emissions have been going up the entire time. Just assume the same types of effects will exist in 2100. Has anyone attempted this?
It’s pretty obvious that any money spent on sea level rise mitigation in 1940 would have been a waste. Probably true for many of the other future claims.
In places where money needed to be spent on sea walls and other climate/weather related infrastructure… it generally was spent, if funds were available.
“In places where money needed to be spent on sea walls…”
Money should never be spent on sea walls. Portable storm surge reduction is the way to go.
The reason “social cost” economists favor low discount rates is because that’s the only way to justify their pet projects. Every thing else in the way of an explanation is smoke and mirrors to achieve that end. Any economist who uses the word “fair” is trying to slip his hand into your pocket. The fact of the matter is that future dollars (or euros, or whatever) are worth less than today’s dollars. That’s the discount rate. It can’t be any lower than the inflation rate, and it better be higher (arguably, a lot higher) to account for risk and the “pain” of forgoing the purchase of tangible goods today for the promise of “better” temperatures tomorrow.
It really comes down to the fundamental differences between the business world and academia/government.
agreed
I’m really pleased that WUWT offers people on the other side of the debate an opportunity to post articles here. It so nicely contrasts with how the CAGW people so often try to suppress open discussion of differing viewpoints.
I wish we could pull in more. Will be working on that.
+42 x 1042
It makes skeptics a class above the CAGW devotees, and also keeps those same folks more honest, as here, we have free and unfettered access to the First Amendment, Freedom of Speech. But not only that, the free and fair exchange of ideas and an open debate that will be published if it is not obscene on some level. This is the key to a fair and future prosperous open society, which is the greatest right that the individual can possess. Without this basic right, it is a return to the Dark Ages. Witness every failed Socialist/Marxist state… Venezuela just being an example of the latest failed state.
Are there practical examples which actually suggest that discounting by as little as 2% was efficient over a period of 50-100 years? Technology advances alone would almost surely make such an investment worthless. In 1919 you could spend the entire wealth of the world on treatments for polio and make no impact. Yet with 50 years it was possible to almost eradicate the disease for a relatively minor cost. Low discount rates rely on a static model of the world to justify spending on inefficient future objectives; there are many better investments including those that can improve the lives of the poorest in the world.