The future is certainly uncertain

By Stephan Lewandowsky
Professor, School of Experimental Psychology and Cabot Institute, University of Bristol
Posted on 8 May 2017
Filed under Regulation, Specific Solutions

The future is uncertain. So how do we best cope with this uncertainty? Nowhere is this question more acute than in the climate arena where today’s policy decisions have an impact on people centuries hence.

The existence of scientific uncertainty has often been used in support of arguments that climate mitigation is unnecessary or too costly. Those arguments are flawed because, if anything, greater uncertainty about the future evolution of the climate should compel us to act with even greater urgency than if there were no (or less) uncertainty. I published two articles that sketched out this analysis a few years ago, and in earlier posts I explained their underlying logic and mathematics in some detail here, here, and here. Climate scientist Michael Mann also made this point during his recent Congressional testimony to the House Committee on Science, Space, and Technology.

In a nutshell, uncertainty is not your friend but a Dutch uncle advising you to roll up your sleeves and start working towards climate mitigation.

Our initial work was not the final word on the matter, but it stimulated follow-up research by an economist from the UK, Mark Freeman, who together with colleagues Gernot Wagner and Richard Zeckhauser from Harvard’s Kennedy School, published a more extensive mathematical analysis of the problem that came to roughly the same conclusions.

One limitation of our existing work on uncertainty has been that we were unable to say anything that was specifically policy relevant. That is, although we could make a strong case for mitigation and against “business as usual”, we were unable to specify how much mitigation would be appropriate on the basis of our work to date.

An article that just appeared in the journal Global and Planetary Change, authored by me and Mark Freeman and Michael Mann, tackled this problem. The article is entitled Harnessing the uncertainty monster: Putting quantitative constraints on the intergenerational social discount rate, and it does just that: In a nutshell, it shows how a single, policy-relevant certainty-equivalent declining social discount rate can be computed from consideration of a large number of sources of uncertainty and ambiguity.

I have written a series of posts that unpack this rather dense summary statement of our article and that will appear here during the next few days:

  • In the remainder of this post, I describe the basics of discounting.
  • The next post describes the ethical considerations that enter into setting of the discount rate.
  • A further post explains how uncertainty about the proper discount rate can be “integrated out” to yield a single certainty-equivalent declining discount rate.
  • A final post explains our simulation experiment and the results.

Discounting the future[1]

We value the present more than the future. When given the choice, very few people would prefer to wait a month to receive $51 if the alternative were to receive $50 today, even though the accrual during this delay would correspond to a whopping annual interest rate of nearly 27%.

This entrenched preference for the present, and the discounting of the future it entails, appears to be an immutable aspect not just of human cognition but of organisms more generally. When given the choice between a smaller reward now or a larger reward later, most animals generally prefer the immediate reward.

In humans, decisions relating to the present involve regions of the brain (viz. limbic and paralimbic cortical structures) that are also consistently implicated in impulsive behavior and cravings such as heroin addiction, whereas decisions that pertain to the future involve brain regions (viz. lateral prefrontal and parietal areas) known to support deliberative processing and numerical computation.

Our strong preference for immediate rewards may therefore reflect the proverbial “reptilian brain,” which competes with our “rational brain” that is telling us to consider and plan for the future.

However, that does not mean that discounting is irrational: On the contrary, discounting is a standard aspect of inter-temporal decision making in economics. Whenever costs and benefits of projects are evaluated, the comparison must be adjusted by the delay between current costs and future benefits (or vice versa). This is done by setting an interest rate known as the discount rate.

The discount rate is at the same time both quite simple and surprisingly nuanced. For now, let’s focus on its simplicity and introduce it with the following example: Suppose you are faced with the decision whether to attend university now, thereby incurring tuition costs and deferring earned income, or to enter the job market straight away. Ignoring all non-economic variables (not recommended in reality!), this decision boils down to figuring out whether the cost of tuition and deferred income will be recouped in the future by the higher income you are likely to earn with a university degree than without one. (A peer-reviewed paper that works this out in detail can be found here.)

Economists often use the prevailing market interest rates to make inter-temporal decisions of this type. To illustrate, let’s suppose the prevailing annual interest rate is 3%. Let’s furthermore suppose you are trying to decide whether to service your car engine now, because you have a pretty good idea that if you didn’t, you’d incur a repair bill of $100 in a year’s time. Now here is the crucial feature of discounting: If you had a $100 now and invested it at 3%, then you could pay the damage in a year’s time and pocket $3 profit. Or conversely, the damage of $100 in a year’s time is only “worth” a little over $97 today (because $97.09 invested at 3% would be $100 in a year). Thus, an economist might argue that you should get your car serviced now only if the cost is less than $97—any more than that, and you’d be better off investing the money and using it to pay off the future repair bill.

This trivial example illustrates the discount rate: it is simply the interest rate you would accrue on current costs (or benefits) until some future point in time when the benefits (or costs) come due.

Determining the discount rate for personal decisions, such as whether to service your car or attend university, is relatively straightforward because we have a very good historical record of the prevailing interest rates and may extrapolate those to the medium-term future with some confidence.

Enter climate change.

The situation changes dramatically when inter-temporal decisions cross generational boundaries and extend into the distant future. Today's policy decisions with respect to climate change will affect people who have not yet been born, and whom today's decision makers will never meet.

The extended temporal horizon renders the setting of the discount rate ever more important and tricky. To illustrate, suppose climate change will cause $5 trillion (i.e., $5,000,000,000,000) in damages by the end of the century. At a discount rate of 1%, this would be “worth” $2.2 trillion today—a whopping amount, to be sure, but still less than half the value at the end of the century. At a discount rate of 3%, this damage would be “worth” around $430 billion today—considerably less than at 1%. Incidentally, $430 billion is a little over two thirds of the U.S. military budget. At a discount rate of 7%, finally, the damage in today’s dollars would be only $18 billion, an amount equivalent to the foreign investment in Vietnam during 2016.

Seemingly slight variations in the discount rate can thus make future climate damages appear either very large (two-thirds of the Pentagon budget or more) or small (Vietnam is a pretty small economy). Taking mitigative action is more compelling in the former case than the latter.

The choice of an appropriate discount rate for climate economics has therefore been hotly contested in policy, economics, and ethics. This debate has failed to yield a consensual value, with some scholars proposing that the discount rate for climate change should be negative and others permitting rates of 5% or more.

In the next post, I discuss the ethical and economic considerations that typically enter into setting the discount rate.



[1] Parts of this section are derived from a post I previously published at https://featuredcontent.psychonomic.org/2016/04/26/when-todays-grass-is-greener-than-tomorrows-gold/

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