Monday, March 28, 2011

Climate Change and Discount Rates

Global mean surface temperature difference fro...Image via Wikipedia
Global Mean Surface Temperature Difference Data
Many analysts have observed that the range of the expected future impacts of anthropogenic climate change is highly dependent upon discount rates.  Depending upon the time horizon and discount rate selected, one can derive almost any desired outcome.  Given this observation, it is crucial that one carefully consider and document one’s reasoning related to choice of discount rate and time horizon when attempting to make credible, defensible climate change projections.

In most benefit-cost analyses (BCA), the application of discount rates to the proposed project’s entire life-cycle costs versus alternative uses for its proposed investment calculates the net present values of the cost and benefit flows of the project and its cash flows[i] versus alternative “risk free” uses of capital[ii].  When the net present value of the project exceeds alternative uses, the project is deemed feasible.

There are at least three methods for determining the discount rate that can be selected—the opportunity cost method, the social time preference method, and the intergenerational method.  Often, public sector officials evaluate investments by using the opportunity cost method.  In this method, discount rates are based upon market rates[iii] in order to avoid crowding out private sector investments.  The actual numbers used are often determined based on investment advisors’ surveys of market rates.  Discount rates selected by this method, if not carefully calibrated, do not adjust for externalities such as the costs of pollution, rising global temperatures, and market power dynamics such as monopolies.  Thus, this type of discount rate is usually inappropriate in climate change modeling.

Another, more appropriate method of discounting is by social time preference discounting.  This concept of discounting arises from the observation that people prefer immediate to deferred satisfaction.  The compensation (or increased utility) that a person (or group) requires in order to defer immediate consumption is measured.  The discount rate is the percentage measure of this compensation per unit time.  This rate is largely a measure of the pure rate of time preference, but it also has implicit elements of relative risk aversion (i.e., the uncertainty in climate change estimates) and of consumption growth rates (i.e., correlated variables that drive the variables which slow or quicken the speed and direction of climate change).  By addressing many timing and input uncertainties and the asymmetry of drivers and impacts, social time preference discounting is an improvement over opportunity cost discounting.

A third, more controversial method of discounting is the intergenerational method.  It can be argued on an ethical basis that there should be no preference between the value of a benefit (or cost) now and the same benefit (or cost) in the future after allowing for the expected probability of the extinction of human beings, such that an intergenerational discount rate might be about 0.1 percent per annum[iv].

[i]  That include allowances for risk by using a “risk free” discount rate (such as T-bills) or by using probability ranges to calculate ranges of net present expected values.
[ii]  The proxy for this is simulating an investment in a risk-free investment such as Treasury bills in an allocation whose maturities correspond with the project’s expected life cycle.
[iii] Social discount rate and liquidity preference (i.e., one’s asset preference distribution (wherein the distribution is by their ability to be easily transferred—i.e., cash is the most liquid of assets)) largely determine market interest rates.  Market interest rates can also be thought of as the discount rate for appraisal of an investment or the cost of capital to the investor with a risk adjustment.   Cost of capital can be calculated as the weighted average of its cost of equity and debt, with the proportion of debt is limited by the risk of insolvency.
[iv] This might also be viewed as the most extreme social time preference method.

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