Guest post by Mark Freeman
On 11th January, Lord Monckton of Brenchley kindly replied (“Of discount rates and candy-canes”) to a guest post of mine on WUWT concerning Nordhaus’ choice of discount rates (“Is Nordhaus’ discount rate really too low?”, 4th January). This is a response to a number of issues around the choice of the social discount rate that Lord Monckton raises.
In my original post, I highlighted that there are two fundamentally different positions on social discount rates (SDRs). The “normative” position is concerned with how governments should discount – working it all out from first principles. Lord Stern in the Stern Review and the UK Government primarily take this approach. The “positive” position says that we should take discount rates directly from financial markets or the rates of return available to private capital. The US Government and Nordhaus largely adopt this method.
Let me start with a real risk-free normative discount rate. There are many approaches that could be taken here, but a standard extended Ramsey Rule method would be as follows. The discount rate would have three components: a utility discount rate that potentially includes a societal catastrophe adjustment + a wealth term – a precautionary savings term.
Taking these in broad-brush terms, the utility discount rate without societal catastrophe adjustment expresses (roughly) how the present value of life itself changes the further we look into the future. Many people think that life has an intrinsic value and should not be discounted. This was Stern’s view and the modal response of our experts. Christian Gollier at Toulouse uses the line “I am not a sexist, I am not a racist, and I am not a timeist” to capture this view. In this case, the appropriate utility discount rate is zero. Others argue that, in practice, we value life in other parts of the world less than in our own country. We provide little help when starvation occurs in Africa, for example, because of agent-relative ethics (see, for example, the discussion in Section 6 here). If we discount based on geographical distance, then there is an argument that we should also discount on temporal distance. There is also an argument that calculations that apply a utility discount rate of zero place too high a burden on the current generation. HM Treasury takes a utility discount rate of 0.5%, which is also our experts’ median response.
The utility discount rate might be increased to account for the possibility of societal catastrophe; society may not be around in the distant future (nuclear war / pandemics / natural disaster / etc.) to enjoy the benefits of today’s investments. Stern adds on 0.1% to the discount rate to adjust for this effect. The higher this risk the higher, not lower, the discount rate. Lord Monckton’s statement that “Laughably, Stern had assumed a 10% probability that global warming would end the world by 2100” is not quite right. Stern does assume there is a 10% probability (1-0.999100) that society will not exist in something like its current form to receive the benefits from climate change mitigation a century from now, but he does not assume that any societal collapse is caused by climate change. In his own words, it captures “the possibility of some exogenous event that would render future welfare calculations irrelevant” (p. 15 here). Second, if he had assumed a lower risk of societal collapse, then his discount rate would be lower not higher. The statement that Lord Monckton makes: “All these me-too economists choosing zero or near-zero utility discount rates and consequently submarket overall discount rates are, in effect, assuming that global warming is likely to destroy the world” is therefore not accurate.
The wealth term captures a “reverse Robin Hood” argument. Most economists believe that the world will continue to get wealthier. Given this, climate change mitigation transfers money from the relatively poorer present to the relatively richer future. The more we care about intergenerational inequality (through the elasticity of marginal utility of consumption) and/or the more we think society will get richer, then the higher the social discount rate should be. Lord Monckton states that “Stern started from the assumption that annual per-capita consumption growth would be depressed by global warming from 2.5-3% to an average of 1.3% over the 21st century.” This is true, but our responses are higher: 1.6% median real per-capita annual growth. As we state in our paper, “This is close to the 2 percent growth rate of consumption per capita in the western world for the last two centuries (Gollier 2012) and the 1.6 percent growth rate in GDP per capita over the period 1900 to 2000 in non-OECD countries (Boltho and Toniolo 1999)” (p.120). So, while these forecasts may be falsified with the benefit of hindsight, they are not obviously unrealistic at this stage, nor out of line with historical precedent.
Finally, although we may think that the future will be richer than today, we cannot be sure. There is macroeconomic uncertainty about the distant future, meaning we might be much richer or poorer as a society than we currently expect. Under a standard economic precautionary savings argument, this uncertainty drives down the discount rate. Because the precautionary savings component is generally believed to increase with the time horizon, this causes the discount rate to decrease with the maturity of the project. This is the declining discount rate effect that I briefly described in my original blog, and that HM Treasury incorporates into its guidance.
Then we come to the question of project, as opposed to macroeconomic, risk. Should social discount rates be risk-adjusted and, if so, how so for a climate change mitigation project? Historically, some Governments have used the Arrow-Lind principle to argue that all social discount rates should be risk-free irrespective of the risk of the project. This view is going out of fashion, with the French, Dutch and Norwegian governments now all incorporating a project risk premium. In my personal opinion, adding such a risk premium is appropriate.
In Lord Monckton’s post, and the original article that I responded to, reference was made to the “positivist” real 7% discount rate recommended by the OMB in the US. But let’s go back to the original documentation on this, which can be found here. First, this guidance is looking somewhat dated given the many advances in this literature over the last fifteen years. But, even taking it at face value, it states that “For regulatory analysis, you should provide estimates of net benefits using both 3 percent and 7 percent”. The 7%, they argue, is an appropriate rate when government spending displaces the use of capital in risky projects in the private sector. The 3% rate reflects a real risk-free Treasury yield for when government spending affects private consumption.
Theoretically, the 7% rate would be appropriate if (i) if governments choose to price risk in the same way as markets, and (ii) climate change mitigation projects have similar risk characteristics to the average investment in the private sector. After all, in the private sector, we do not apply the same discount rate to all projects but instead, through the Capital Asset Pricing Model, adjust for the project beta. In my opinion, neither of these assumptions obviously holds true. The Interagency Working Group on the Social Cost of Carbon felt that the 7% rate was not appropriate for climate change mitigation. The upper rate was reduced to 5% (incorporating a project risk premium) and a lower rate of 2.5% was added alongside the 3% rate. The 2.5% rate, as well as allowing for declining discount rates, reflected the theoretical possibility that climate change mitigation is a hedging (negative beta or insurance) investment and so should offer lower rates of return than are given by Treasury securities. This has been argued by some in the academic literature. A recent paper by Dietz, Gollier and Kessler, here, is the current state of the art on this question and they argue that the risk premium should be positive.
In practice, the French government allows the risk premium to rise with the project horizon because of increasing project risk over time, offsetting the declining discount rate effect of precautionary savings, meaning that the overall French social discount rate is horizon-independent at 4.5% real (for a beta=1 project). In Norway, both the risk-free component and the risk premium decline with project maturity. As a consequence, the discount rate drops from 4% at the short end to 2% at horizons of 75 years or more. The Dutch rate is 3% real, including risk. But as Dietz et al. also argue, as project beta increases so do the expected benefits of climate mitigation projects and, overall, the estimated NPV of climate change mitigation projects increase compared to a risk-free analysis.
So, what approach does HM Treasury in the UK take? It incorporates a term that combines both the risk of societal collapse (which is a component of the risk-free discount rate) and a CAPM-type risk adjustment. “The risks contained in L could, for example, be disruptions due to unforeseeable and rapid technological advances that lead to obsolescence, or natural disasters that are not directly connected to the appraisal. L also includes a small premium for ‘systemic risk’ because costs and benefits are usually positively correlated to real income per capita”. HM Treasury recommends a discount rate of 3.5% real at the short end declining to 2.5% after 75 years. See Appendix 6 for the discussion of all these matters here.
Of course, Stern argues strongly against any positivist approach. “It must surely, then, be clear that it is a serious
mistake to argue that the SDR should be anchored by importing one of the many private rates of return on the markets (or a rate from government manuals, or a rate from outside empirical studies). Yet it is a mistake that many in the literature have made … Such an approach is entirely inappropriate given the type of nonmarginal choices at issue and the risk structure of the problem, and in light of developments in modern public economics,
which encompasses social cost-benefit analysis and which takes account of many imperfections in the economy, including unrepresented consumers, imperfect information, the absence of first-best taxes, and so on” (p. 13 here). Not all agree with him on this point, Nordhaus for one, but this is a mainstream opinion.
Overall, a real risk-free social discount rate of 2% for intergenerational projects seems, to my co-authors and me, to be highly defendable. There are good arguments to add a premium onto this if you are discounting expected cash flows from risky projects, and this might get us close to 5% (we do not survey on this point). But, within the context of existing government guidance where risk premiums are included, this looks to be towards the upper estimate. This is reflected in the take-away from my first blog post that Nordhaus lies at the top end of economists’ views on these matters without being an outlier. And Dietz et al., would say that allowing for risk in the discount rate but not in the expected cash flows will bias any NPV estimate downwards. Stern, by contrast lies at the lower end of the distribution of expert opinion in a purely risk-free environment.
Mark Freeman
14th January 2019
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“societal catastrophe adjustment + a wealth term – a precautionary savings term”
So, 3 DOF’s of arbitrary adjustment to the most vital parameter to assess future value of climate actions today.
No wonder no one trusts economists. And no one should.
I disagree. Ordinary commercial project discounting should be applied, and as Rud Istvan pointed out, trying to estimate the value of a project more than 30 years out gets to be useless, as the technology will change.
Pretty much, the only persons using the “discounting” used here are governments, who by definition spend other people’s money.
Yes, Tom. That at least comes close to, “How much return will it take to convince you to forego current consumption for this project?”
It is the combined desire of all current ‘lenders’ to participate in the project at the rate agreed upon. If the project were to give my descendants 100 years hence $1 Billion each, I might be more inclined to participate compared to a non-problem-solving project to save the earth from the Climate Change Lunacy.
Since we’re talking about tax money, my desire to spend zero dollars ought to counter weigh a Green Zealot’s willingness to spend a large share of his current income/wealth. Trying to convince me to give up my money for Freeman’s socialism just doesn’t work for me.
In reality, one CANNOT reasonably bring discount rates into the climate question at all, because
… for projects at such scale, the assumed discount rate is a variable that is internal to the system, and should be termed as the “self fulfilling prophesy rate of return”.
With energy suppressed by policies that are set by a 0% rate analysis, society will of course be run down by the analysis itself.
(and the common sense bigger picture … any non-biased common sense non-idiot can see, just by looking, that the cost of mitigation exceeds that of adaptation by one or two orders of magnitude.)
Uh, no.
For anything that has a series of cash flows (positive and negative) in the future, one must use a discount rate.
This series of posts has had my head spinning, until I realized both authors are brits, and are therefore schooled in communist economic theory.
I thank them for trying to translate it into capitalist financial engineering, but I fear they’ve both failed terribly.
Stupid comment. The UK is home to one of the world’s biggest financial centres – you think that is because all those bankers, financiers and others don’t udnerstand discount rates?
They understand full well how to manipulate discount rates for present profit …
So anything you don’t understand must be some kind of communist conspiracy.
There must be a lot of communism out there.
A standard approach to estimate future damages is to take historical damages and extrapolate. I don’t see it happening. Instead, we are “forecasting” damages which no one has seen. It is a pure witchcraft. I don’t care whether witches are using normative brooms or positive brooms. I don’t trust them.
Agreed! Since we have supposedly seen about one degree Celcius of warming since the Industrial Revolution, we can examine the result of that “climate change” and find, not only is there NO “damage” inflicted to society by the warming climate, but there is MASSIVE BENEFIT inuring to society as a result of the warmer climate.
So the whole question of a “discount rate” is a non-issue; not only is there NO “benefit” to be gained by implementation of “climate policies” aka “mitigation,” it would be PURELY DETRIMENTAL and therefore has NO value, even if we make the generous assumption that the “climate pseudo-science” is accurate. It would be ALL “costs” for ZERO “benefit.”
Not to mention that TEENSY little fact that there is NO evidence that atmospheric CO2 levels, or the minuscule human contribution thereto, have anything to do with the changes to the climate that have occurred, and therefore any attempt to “mitigate” the non-issue of CO2 emissions would be futile.
SDRS are an attack on the $, currently the world’s dominant currency, and the major target of the EU and China.
Failing to provide the science to back their claims the pro AGW crowd is now going after economic instability to bolster their claims of legitimacy. Has nothing to do with the intrinsic question of temperature. The “moral” and “social” angles of attack haven’t worked because those supposedly affected have mores sense the purveyors of the propaganda disguised as news.
If only the Stern Review had been implemented internationally seventy years ago.
Here in the Southern Hemisphere it wouldn’t be 33C outside but only 32.4C — outside and inside.
This investigation of discount rates presupposes that there is some actual change or danger apparent or certain and needing to be dealt with. So far no proof has been offered that increases in CO2 are doing anything other than green the planet with happy plants. This is putting the cart before the horse. First comes the proof, then the action.
YES – This.
I’m so sick and tired of all this debate about something which there is no basis for to begin with.
NO proof = NO “problem” = NO need for “action.”
They might as well measure the rate of the incoming tide, extrapolate the rate 100 years into the future, declare catastrophe, and demand “action” to “stop the tide crisis.”
THAT is essentially what they are doing, just with something whose time scales of change make the buffoonery of it less obvious.
How many military strategists employ only one strategy when planning a battle?
Attacking this nonsense on multiple fronts is a good idea.
Also, different arguments carry different weight with different people, depending on what their background and experience is.
The strongest argument for you may not be the strongest argument for everyone else.
Attacking the mis-use of the discount rate would be something that attracts the attention of economists and anyone who does industrial planning.
Going after the discount rate obviates everything else. If a 7% discount rate zeroes out all of the speculative benefits of carbon taxes and regulations… the science (or lack thereof) doesn’t matter.
I stand at 7%. I have seen no valid reason that argues a capital expense should not expect a capital rate of return.
Public funds are being diverted to alternate investment paths, the appropriate consideration is whether these alternate investments produce a net benefit that exceeds the wealth generated from standard market investments.
Risk mitigation may have a lower rate of return than public markets but that’s not a valid reason to argue for spending on risk mitigation.
Lets say I have a house that could explode at a specific point in time far into the future Y. If I buy technology X and it prevents my house from being blown up, the appropriate consideration is not how much my house will be worth at point Y but how many equivalent houses I could buy at time Y from investing the technology X money in the most average and/or lucrative ways possible.
If I save 1 house but lose out on the opportunity for 5 houses technology X is a bad deal.
If current mitigation proposals were profitable that would be one thing, but accounting for their externalities, to the grid, environment, and actual costs they are a net sunk cost. We should treat them as such.
Hmmm.
I wonder if this is one on those NKANGAFE situations
Nobody
Knows
And
No one
Gives
A
F…..
Either..
Far better to sort things out as they should occur. True that approach may be a bit hard on some people, but overall it will work out for the better. Historically with the rises and falls in the economy we collectively have done OK. I believe its called “Free Enterprsze”
MJE
Freeman: You nedd to have a surgeon remove your cranium from your rectum.
Time is the only thing that there is. Interest is a payment for time. A low discount rate is a claim that time has no value. Humanity does not behave as if time has no value. We cannot, because time is the only thing that there is.
I don’t know why market interest rates have been so low since the Panic of 2008. Nobody does. But, I know that they are too low, because they do not put a reasonable value on time. I suspect that the low market rates are a warning flag about the collapse of the fiat currency system and the the welfare state regimes of western Europe and north America.
Be that as it may. low discount rates are nonsense, because they do not put the proper value on time.
The modern day equivalent of negative discount rates is the old fashioned stamp tax which encourages circulation of currency rather than hoarding.
You ignore risk. The idea that putting $100 into two projects should have the same return just because they have the same “time” is absurd. Are you happy to take the same return on a ten year US bond as on a ten year Venezuelan bond?
Business usually discounts at a rate that it habitually achieves or its cost of capital.
Since governments usually fail to make any return on “investment” they could make the illogical case for a zero discount rate and assume the present value of future cash to be infinitely large.
Using a valid financial method on the basis of capricious estimates is pseudoscience.
Virtually every commenter above as of January 16th at AM EST, I completely agree with!
I particularly like Curious George’s simple comparison summation to witchcraft.
Applying opinion driven subjective and arbitrary discount rates for fantasies and fears is absurd. Both fantasies and fears are illusions spun by alarmists addicted to draining fear driven funding.
Nor do I consider Stern to be worth reading or considering. His fantasies have been on record for well over a decade and bear no resemblance to the real world.
Nor is there any sound reason why people should assume the future generation will be less or even equal to any risk or task than our efforts.
* Future generations will have the advantage of better data, if valid truly accurate data collection and maintenance is established. Something that does not exist today.
* Future generations will have far better technology to address real risks.
* Future generations should have far better understanding of what the data means! That is, if climate science ever returns to real science instead of almost daily poorly researched never validated fear mongering papers.
* Wealth redistribution is a falsehood!
Wealth redistribution does not factually exist and every attempt to implement wealth parity devastates countries and their populations through bureaucratic burdens, micromanagement, innovation phobic leaders, freedom of speech phobic leaders and a thorough squelching of citizen ambitions except for politics.
This still fails to consider any possibility that the money spent now will be inefficient because:
a) climate models are imprecise
b) estimates of the cost of harmful effects are imprecise
c) wind and solar technology improves over time as does battery storage
d) other cheaper and more cost effective technologies may be discovered
e) we cannot predict natural cooling of the earth countering some of the effect of CO2
f) all countries may not (do not) carry out the agreed actions negating or reducing the value of those that do
It seem quite unreasonable (actually downright arrogant) to consider that we are so certain now that nothing will change over a period of 100 years. Further, the concept that discounting is somehow immoral or “time-ist” is quite laughable. Would a zero discount rate have been appropriate back in the 60s and 70s if we followed the recommendations of the doom merchants predicting overpopulation, food, energy and resource scarcity? Yet the year 2000 came and half the population of the world wasn’t dead, people had more food than ever before, we hadnt run out of oil and the price of almost every commodity had decreased.
Bottom line is that the uncertainty is such that we have no idea of the right discount rate, but history teaches us that we will very likely have a better solution 30 years from now.
I can make 3 percent by owning 30 year T bills. Therefore, any investment I make had better earn more than 3 percent. What’s so hard about that?
But you can’t get 3% real (inflation-adjusted) on US Treasuries at the moment. As of last night, TIPS are offering 1.21% real at 30 years. Nominal (including inflation) rates are 3.08% but all the discount rates I have referred to are real. https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=realyield
https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield
Well I certainly wouldn’t use 1.2% as an opportunity cost to base investments on.
And this analysis just ignores opportunity cost. Discussing discount rates without discussing opportunity cost is pointless. Discount rates were invented to bring some sort of order to analysing opportunity cost.
Yep. Here’s a simple example even the alarmists should understand:
“Investing” $40 trillion now in climate change mitigation schemes would deprive the world of $40 trillion that could have been socked away in government bonds to fund future climate change adaptation needs.
There’s the missed opportunity to sit on beaches in Hawaii and Puerto Rico … Oh wait … They manage it anyways …
These discount rates greatly underestimate the costs of acting on climate change now instead of acting on important issues now.
Inter-generational inequality is a meaningless concept if the future generations aren’t even born because grandma died of dysentery.
We could provide clean water today or we could fight the weather a century hence.
If your sums say you should do the latter you’ve got them wrong.
Around 1820, the swedish navy was worried about the supply of raw material for shipbuilding, so they decided to take action.
On the island Visingso, some 300,000 oaks were planted.
The project went just fine, oaks cared for and grow, as oaks do.
But, when the steward reported back to the navy, that the oaks are ready for harvest the answer back was: We dont want them now – it is 1980 and we use steel these days.
I’m not sure why Dr. Freeman felt he had to defend himself to Lord Monckton and get caught up in the useless nuance of discount rates. When Moncton calculates abatements equal to a reduction of .000002 degrees centigrade for the French fuel tax, that is the real eye opener of his message. Lord Monckton only seems to go through the discount rate discussions in order to provide his bonafides on the subject of discount rates so people will take his abatement calculation seriously.
It’s never been clearer that the economic losers in all of the climate change mitigation are the poor people of the world. Nevertheless Dr. Freeman had to subtly qualify himself as not being racist or elitist by quoting Gollier. Yet he clearly made the point that there is a low discount rate on lives in the first world while there is a very high one on the third world poor(mostly people of color). It’s simply a racist elitist argument he presented.
A couple of decades from now when the worlds elites have to abandon global warming as it will become continuously more difficult to justify it as data continues to go against them, they will not abandon their belief that they have a greater right to the worlds resources than the poor people of color.
Monckton was never so right.
These are the yields on standard Treasury bonds, which give returns in non-inflation adjusted terms. That is, they promise you payoffs in dollars, not inflation-adjusted dollars. TIPS do adjust the payoffs for inflation and these are reflected in the US Real Yield Curve. Another source (although, of course, same data) here: https://www.quandl.com/data/USTREASURY/REALYIELD-Treasury-Real-Yield-Curve-Rates
The 3 percent rate reflects the opinions of many experts on the long term prospects of the US in present day dollars. Now in applying expected inflation rates and nebulous concepts such as technology, climate change, population growth, etc, etc, are we really getting closer to the truth? What if the alarmists are right?
“What if the alarmists are right?”
It is possible to accept as true the most extreme of all the alarmist scenarios and STILL come to the conclusion that based on the economic trade-offs, we should do nothing presently.
Solar and windmills availabilities are beyond dispatcher control. Simply put, they can not be scheduled.
And no one takes into account the risks induced by a potentially unstable electric grid and the consequential unreliable power supply.
Industries, hospitals, buildings, are concerned.
Up to the extend when recently en-route to Hambourg we faced a possible diversion or long holding times due to “probable unreliable power supply to ground facilities”.
15-20 arrivals were concerned, someone could have been hurt, weather was in a moist freezing mood (think Colgan 3407, in-memory).
Luckily they managed to take us all on time.
i) It’s not the government’s money. It’s the private sector’s money. There is no special virtue or logical reason for the government to price risk any differently than the private sector, from which they confiscated the money.
ii) Climate change mitigation schemes are inherently riskier to the investor than any other capital allocation and of no benefit to the investor. Any value imparted to future generations is 100% speculative.
This sort of “investment” doesn’t even rate junk bond status.
Except from the perspective of the rich, politically connected, virtue-signalling scum that are lining up to profit from it at taxpayer expense.
However since the whole climate debate is a scam and hoax then all these words on discount rates are just a waste of space.
Not at all. Forcing government to abide by real world accounting principles might effectively end regulatory overreach in all areas
Climate change mitigation is neither a hedge, nor insurance. Socking money away in a climate adaptation fund would be a hedge or an insurance policy. However, governments are 100% untrustworthy when it comes to socking away money or even competently managing it.
Choosing a discount rate is a bit like choosing a Climate Sensitivity value. Take your pick and you can get any prediction you like.
Now, when you have to choose both. …… Well that is a bit of a dilemma is it not?