We must discount, but how much?

An article that just appeared in the journal Global and Planetary Change, authored by me and Mark Freeman and Michael Mann, reported a simulation experiment that sought to put constraints on the social discount rate for climate economics. 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.

In a previous post, I outlined the basics of the discounting problem and highlighted the importance of the discount rate in climate economics. In the remainder of this post, I will outline the ethical considerations and value judgments that are relevant to determining the discount rate.

Because those considerations may yield unresolvable ambiguity, they must be “integrated out” by a process known as gamma discounting. This will be explained in the next post.

A further post will explain our simulation experiment and the results.

Considerations about the social discount rate in climate economics

When individuals or businesses make decisions about investments, they tend to use the prevailing market interest rates to set the discount rate. This approach, known as the descriptive approach to setting the discount rate, makes perfect sense for short or medium-term time horizons when the costs and benefits of a project involve the same people and the same markets. The approach is called descriptive because the discount rate correctly describes how society actually discounts, as determined by the markets.

An alternative approach, called the prescriptive approach, prefers to estimate the social discount rate directly from its primitives rather than using market rates of interest. In this context, the discount rate is usually called the social discount rate because it applies not to individuals or firms but to society overall. The approach is called prescriptive because it imposes a rate on social planners that is, at least in part, based on value judgments.

There are a number of arguments that support the prescriptive approach.

For example, many economists and philosophers would argue that we cannot discount with respect to future generations. That is, present-day decision makers should not endorse policies that inevitably disadvantage future generations, who have no power to resist or retaliate against present-day decisions. In addition, those most affected by climate change—the poor, often in developing countries—do not influence market interest rates. This arguably places a burden on governments to take a wider ethical perspective than investors who trade in financial markets. 

Our article therefore took the prescriptive approach to setting the discount rate, consistent with governmental recommendations in the UK and much of Europe. (Although US authorities have generally preferred descriptive approaches to intergenerational discounting.)

The prescriptive approach is conventionally understood within the framework of the Ramsay rule:

ρ = δ + η × g.

It can be seen that the social discount rate, ρ, results from two distinct components: A component known as the “pure time preference”, encapsulated by δ, and a component that combines the expected average annual real economic growth rate, g, with a parameter η that turns out to capture people’s inequality aversion. (It also does other things but here we focus on inequality aversion).

The pure time preference is simply our impatience: It’s our impulse that $50 today is “worth more” than $51 in a month, even though the accrual during this delay would correspond to a whopping annual interest rate of nearly 27%.

The rationale for inclusion of the growth rate is that growing wealth makes a given cost for future generations more bearable than it appears to us now, in the same way that $100 is valued a great deal more by a poor student than by a billionaire.

Within the Ramsey framework we thus have to consider three quantities to determine the social discount rate: Future economic growth, inequality aversion, and pure time preference. Future growth rates can be estimated by economic modeling—and that is precisely what we did in our article, and I will describe the details of that in the next post.

Determination of the other two quantities, by contrast, involves ethical value judgments that are necessarily subjective. (Given the inter-generational context, we ignore the possibility of estimating η and δ from asset markets and behavioral experiments, respectively.)

To illustrate the ethical implications I focus on δ, the pure time preference. I will ignore issues surrounding η for simplicity.

It has been argued that it is ethically indefensible for δ to be greater than zero, as it would embody “a clear violation of the attitude of impartiality that is foundational to ethics”. That is, we should not disadvantage future generations simply because we happen to have been born before them. If one wanted to treat future generations equally to ours, as most people seem prepared to do, one would therefore want to constrain δ to be zero—and indeed, in the U.K.’s influential Stern report, δ was set to (near) zero for that reason.

However, the seemingly attractive idea of treating all generations equally by setting δ to zero entails some unnerving consequences. In general, the lower the discount rate, the more future consumption (or cost) matters and hence the more we should set aside for the benefit of future generations. Partha Dasgupta computed the mathematically implied savings rate when δ is set to the value recommended in the Stern report and found it to be 97%. That is, out of $100 we currently own, we may only consume $3, with the remainder being tucked away for the benefit of our children. Our children, in turn, would also only be allowed to spend $3 of their considerably greater wealth, with the remainder being passed on to their children, and so on. An implication of d being near zero therefore is the impoverishment of each current generation for the benefit of the succeeding one!

And it doesn’t stop there: low discounting, although it may appear benign in the climate context, has dangerous implications elsewhere. As William Nordhaus put it: “Countries might start wars today because of the possibility of nuclear proliferation a century ahead; or because of a potential adverse shift in the balance of power two centuries ahead; or because of speculative futuristic technologies three centuries ahead. It is not clear how long the globe could survive the calculations and machinations of zero-discount-rate military strategists.” 

So what is the “correct” value of δ?

We don’t know.

But we do know that in a recent survey of 200 experts, Moritz Drupp and colleagues found that the distribution of expert responses was closely approximated by setting δ to zero with 65% probability and setting it to 3.15 with 35% probability.

So now what?

Do we make policy decisions based on majority rule? Or based on the average of the two sets of expert opinions? Or do we decide that experts are no good and that we should ask Bruce at the pub?

The next post presents a solution to this dilemma known as gamma discounting.