Scientists agree that immediate action to curb greenhouse gas emissions is necessary. But how much action is needed? And how expensive will it be? When you see flashy headlines like this one in the news channel CNBC: Climate Change Mitigation Could “Cost U.S. $90 trillion by 2030”, have you ever wondered where they get those figures from? Well, of course there are several factors that determine it but whether that figure is in the millions or billions (or is a net loss or net benefit) can be determined by one small part of the equation – the discount rate.
The discount rate of time is an idea that reflects that people in general prefer to consume goods sooner rather than later. People would generally prefer $5 today than $10 in a year’s time. This implies that people are willing to sacrifice certain benefits later to enjoy others sooner. The idea also works in reverse with putting off costs for later rather than taking them on now. The discount rate ranges between 0 and 1, with a higher discount rate meaning a higher importance is placed on now rather than later, and that a lower discount rate brings the future and the present closer to parity.
In the context of climate change then, a higher discount rate means people devalue the future costs of climate change in favour of the benefits of using greenhouse gases today, thus decreasing the amount of action needed in the short run. Conversely, a lower discount rate would result in more aggressive mitigation efforts right now. So, in calculating how much to spend on climate action and when to spend it, these time preferences are vital to the equation. The final answer of how much to spend is greatly affected by the choice of the discount rate.
There are also broad subsections of discount rates, which makes it ever more granular and complex, and the rate of time preference does make up only part of the discount rate, but I will leave out these parts for simplicity. All that I would like to include is that we are discussing discount rates for generations, not sole individual preferences, which comes with a whole new set of ethical considerations. This then means that a lower discount rate places more focus on the welfare of future generations and a higher discount rate places more importance on the welfare of this current generation.
So how do you choose the discount rate? The choice has long been debated in public policy and in many fields of economics. Environmental economics is no different. There are two main viewpoints on how to calculate the discount rate, which I see as empirical versus ethical. Of course, I am heavily simplifying their views here and there are more nuanced thoughts on either side, but it is essentially an almost bipartisan debate.
Why am I telling you about this? I am not going to be telling you the correct way to choose the discount rate because I don’t know that. Rather, I believe this obscure part of climate economics can tell us a lot about the heart of climate change. The way that policy makers will choose the discount rate will reflect how we as a society tackle this looming problem.
On the one hand we have the economic, efficient argument which tries to incorporate markets and their preferences into decisions about climate policy. This is the empirical category. On the other hand, we have a more normative, flawed argument, in favour of pushing society to where they should be (and maybe not necessarily from where they are). This is the ethical category.
The two famous proponents for each side of the debate are William Nordhaus and Nicholas Stern. In 2006, Stern and his team published The Stern Review at the request of the government of the United Kingdom to add more economics to climate change policy. In it, he discusses the discount rate and his views fall into my ethical category. On the other side we have Nobel prize winning economist William Nordhaus, who published A Review of the Stern Review on the Economics of Climate Change in 2007. He criticizes the report on its theoretical basis and not putting market rates in a more central role in the discount rate, among other things. He falls into my more empirical category. Stern advocates for a lower discount rate (around 0.1), while Nordhaus argues for a higher discount rate (around roughly 0.5). This may not seem like much, but a difference of 0.1 (from 0.3 to 0.2) in the discount rate between the US Environmental Protection Agency and the Obama Administration led to a difference valuation of the price of carbon, changing the price of carbon per tonne from $52 to $125.
For me, I do think Nordhaus’ argument has some significant merits. It is also founded on more reasonable economic theory and therefore may be more efficient in bringing us closer to our stated goals (limiting warming to a certain degree above pre-industrial levels). However, while Nordhaus does provide some room for philosophical reasoning in choosing the discount rate, it always seems to fall second to efficiency. While this is often the case in economics, I believe it is especially remiss for this particular question. Furthermore, it is worth keeping in mind that the markets that Nordhaus uses for the discount rate are inherently flawed.
Stern’s argument may also have flaws in its philosophical argument (with a flair to prescribe that what was best for Britain is the best for the world and the future), but at least ethics takes centre stage in his report’s arguments. While Stern’s methods may not be more productive in getting to our stated goals, it could take society beyond that. Wouldn’t it be great if instead of only working to avoid the worst scenarios with our climate, we used this to reverse that trend and strive to make things better (possibly even better than they once were)? One can dream now and again.
So, in this brief overview of an old and yet still current, complex debate, I believe you can find one of the largest tugs of war happening in climate change policy. Do we rely more on empirical, logical arguments that incorporate and reflect today’s society more accurately? Or do we try to strive for something more, even if it means it may possibly not work as well? Whichever team wins this contest I believe may play a large role in determining the future of climate and our relationship with the planet.
My hope is that those who sit with these decisions in their hands decide to place more emphasis on a green future than merely what is ‘efficient’.
P.S.
Now that you know what the discount rate is, keep your eye out for it in the news. When you see a flashy headline about the costs of climate change, try and figure out what discount rate they used. Politicians on the left and right tend to cite studies with discount rates that are more convenient to their ideologies. If you see something too high (for example the Trump administration liked using a discount rate of 0.7, which essentially implies no one cares what happens after 25 years), then maybe think twice about its results
If you’re interested
There are of course people who advocate for using alternatives to discount rates, or different formulas for the discount rate (such as using hyperbolic discounting, which has been proven to reflect human emotions more accurately)
A lot of economists have argued for more front-loading of climate change mitigation due to the very low interest rates experienced for the past few decades, this has now reversed with interest rates hikes accompanying worldwide higher inflation, meaning mitigation now will be more expensive than previously planned
Martin Weitzman is also a famous advocate for lower discount rates to combat climate change. You can find his article here
Currently, the Biden administration seems to have settled on a discount rate of 0.2.
It is also worth noting that, since the beginning of the debate, the rift between Nordhaus and Stern seems to have lessened
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