What is the appropriate discount rate to use in assessing climate change mitigation policies?

The correct answer, in my view, is that the appropriate discount rate depends on the kind of policy that is being considered. If that answer seems odd to you then there is a good chance you have not yet read Mark Harrison’s paper entitled ‘Addressing Wellbeing in the Longer-Term: a Review of Intergenerational Equity and Discount Rates in Climate Change Analysis’. The paper was published last year in Measuring and Promoting Wellbeing, a collection of essays in honour of Ian Castles (an Australian who deserved to be honoured highly for his work on measurement of wellbeing).

The kind of policy that was evaluated in the famous cost benefit study by Nicholas Stern (and the subsequent study by Ross Garnaut) involves imposing some kind of tax (perhaps via a cap and trade mechanism) on carbon emissions in order to improve the well-being of future generations. Stern and Garnaut assume that economic growth will continue even in the absence of policies to mitigate carbon emissions and global warming, resulting in much higher average income levels in future (3.6 times higher 100 years from now in Stern’s projection).

Photo by Robin Ellis. Some rights reserved.

The carbon tax that this kind of modelling exercise suggests to be appropriate is highly sensitive to the discount rate that is used to determine the present value of mitigation efforts. The use of a low discount rate suggests that strong immediate action is warranted to mitigate climate change, whereas a higher discount rate suggests that the most appropriate course of action is to begin with a very low carbon tax and raise it gradually. In an illustrative example Harrison shows that with a discount rate of 1.35%, as assumed by Stern, the optimal current carbon tax is $78.48 per tonne, whereas with a discount rate of 6% it is only $0.88.

The discount rates used by Stern and Garnaut are an application of the social welfare function approach. Social welfare functions necessarily embody ethical judgements, even though such judgements are hidden beneath empirical facts in some versions of the, so called, Ramsey formula used by climate change modellers. Opinions differ on what ethical judgements are appropriate and discount rates can vary widely depending on what assumptions are made. Harrison demonstrates that the Ramsey formula gives estimates of a risk free discount rate ranging from 0.24% to 11% under the range of parameter values used in a variety of studies over the past decade.

At this point some readers will probably be throwing up, while others will be wondering what discount rates would be consistent with ethical judgements that they would be prepared to endorse. One way to consider whether you would be prepared to pay a carbon tax costing you $x per month in order to make your great grandchildren better off is to ask yourself whether you would prefer to make a financial investment of the same amount each month into some kind of trust for their benefit. The answer you obtain by considering opportunity costs in this way is equivalent to discounting the real money value of the benefits of climate change mitigation by the rate of return that you could expect to obtain on the alternative investment – presumably higher than the average real long term bond rate over the past 20 years or so.

One possible objection to this approach is that the rate of return on alternative investments will incorporate an element of compensation for risk, which is not appropriate in considering public investments such as climate change mitigation. The response which Mark Harrison provides is to point out that investment in climate change mitigation are far from risk free. There is a great deal of uncertainty about future costs and benefits of such policies. Most obviously, if you decide to vote for the carbon tax option you have no guarantee that people in other countries will pull their weight by imposing similar taxes on their citizens.

Some of you will by now be thinking that the cost benefit framework outlined above must be a load of garbage because you remain concerned about climate change, even though you would prefer to invest money for the benefit of your great grandchildren rather than to pay a carbon tax. If you are concerned about climate change, you are unlikely to be concerned that your great grandchildren will suffer losses that you could compensate for by increasing your savings rate by a small amount. The chances are that you (like me) will be concerned about the remote possibility that your great grandchildren might suffer from having to live with potentially catastrophic climate change outcomes.

Mark Harrison points out that by explicitly accounting for risk, rather than assuming it away, we can distinguish between policies that reduce risk and those that don’t. Mitigation policies that are potentially effective in averting disasters should be subjected to a discount rate that is below the risk-free rate because they pay off at a time when returns on other assets are low or negative, and when willingness to pay is great.

So, my conclusion:

•  the most appropriate discount rate to use to evaluate policies such as carbon taxes is the long-term average of real market rates of return on capital; and  
• the most appropriate discount rate to use to evaluate policies directed more specifically toward averting disasters - such as public investment in research to develop low-cost ways to removing greenhouse gases from the atmosphere - should be lower than the long-term average of real government bond rates.

In the unlikely event that we are faced with something close to the worst case climate scenario, our current policies to encourage adoption of inefficient alternative energy options are unlikely to avert catastrophe.  If the objective is to reduce the risk of catastrophe we should be using an evaluation methodology that helps us to choose the lowest cost method of achieving that objective.

Postscript:

There seems to be increasing awareness that we should be asking how we can insure against the worst climate change outcomes at lowest cost. Martin Wolf has published a relevant article entitled ‘Climate actions hould be seen as insurance’, in which he discusses Climate Shock, a new book by Gernot Wagner of the Environmental Defense Fund and Martin Weitzman of Harvard University. There has been a fairly favourable review of Climate Shock by William Nordhaus in the New York Review of Books.

I get the impression that the authors of Climate Shock have come to the conclusion that the best form of insurance is to reduce CO2 emissions as rapidly as possible. They rule out engineering solutions directed toward managing solar radiation (probably for good reasons) but it is not clear whether they have considered the potential benefits of research into ways to take greenhouse gases out of the atmosphere.

It is also unclear whether urgent action is justified, given the fact that when global warming resumes it will probably have positive net economic benefits for a few more years. I expect the variance of potential outcomes is not as great over the next decade or so as it is when we look further into the future.

The review article by William Nordhaus offers a solution to the free rider problem in international negotiations in the form of a climate change club  imposing trade sanctions on countries that are perceived to be laggards. That kind of thinking makes me wonder whether the science of climate change might turn out to be less important for a country like Australia than foreign policy and trade considerations. The formation of a climate change club seems a more worrying prospect at the moment than the potential for an increased incidence of droughts and bushfires.