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.
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.