Thursday, August 18, 2011

Discounting the Future

How much is the future worth relative to the present?

At the bottom of many environmental issues is the question of intergenerational justice. Are we passing on the planet to our descendants in as good a state as we inherited it from our ancestors (sustainability)? Or is my generation impoverishing the future? To try to answer this question one needs a way of comparing goods or harms occurring at different times.

The standard economic answer is given by the discount rate or time value of money. A discount rate of 10% means that a hundred dollars in my pocket now is just as valuable as a guaranteed payment of 110 dollars in a years time. Once the discount rate is set, once can compare economic impacts at different times. A high discount rate suggests that future events should have low influence on our present choices. The Stern Review of climate change, commissioned by the British government, recommended radical steps primarily because of its assumption of a much lower discount rate (I think 1.4%), which gave greater value to the impacts of climate change on long timescales. Critics of the review argued, among other things, that this discount rate was unrealistically low in the light of historical data.

But where does the discount rate come from? It reflects our belief that "resources today can be transformed into more resources later" - in other words, that we will keep growing. A high discount rate, which might tell us not to fret so much about climate change, means that we are committing to a high growth rate out into the future; and, things being as they are, that means more energy use, more fuel consumption, more carbon dioxide... and more climate change.

Oops.


3 comments:

b535aad6-c9d8-11e0-9651-000bcdcb5194 said...

The point made in the fourth paragraph in this post may be susceptible to a somewhat more sophisticated analysis.


The discount rate is an actuarial term [see http://en.wikipedia.org/wiki/Discount_rate or http://en.wikipedia.org/wiki/Time_value_of_money] that is used to indicate the 'exchange rate' of 'present' money with 'future' money. Thus, as a number, it is the present price of a unit of money to be acquired at a standard specified point in the future. The discount rate is often closely tied to the interest rate of money, or more generally, the return on liquid, riskless assets. A historical example of this has been the prevailing rate on Treasury bills. (It is of course somewhat uncertain to what extent US Treasury bills will continue to be a broadly accepted standard of a liquid, riskless asset).


The interest rate corresponding to a certain level of actuarial risk and a specified duration of a loan is, in principle, determined by the (expectation of) economic growth or decline over a period of time. For instance, a producer may issue a bond to raise capital for an investment project at a given interest rate (for concreteness, let us assume 10% compounded quarterly) only if (s)he reasonably anticipates, from an actuarial perspective, that the (private or social) return on the investment project will exceed (or at least match) the rate of interest at which the capital is procured. Thus, the prevailing interest rates in the market ought to be influenced by the current standards of technology by which economic factors of production: land, labour, capital and enterpreneurship, can be converted into economic goods. The imputed discount rate thus ought to be partly a consequence of prevailing levels of technical/technological progress. As an aside, there ought to be nothing preventing the prevailing discount rate from being zero or negative, rather than positive, and it has been argued that this has been the case in contemporary Japan [http://en.wikipedia.org/wiki/Economy_of_Japan#Postwar_period_.281945.E2.80.93present.29 and http://en.wikipedia.org/wiki/Zero_interest_rate_policy].


From this it follows the assumption that higher, positive discount rates necessarily imply the expectation of higher growth (or return on investment) is fairly sound.


However, it does not necessarily follow that higher discount rates necessarily imply "more energy use, more fuel consumption, more carbon dioxide... and more climate change" from the perspective of economic theory.


It can be argued that the economic value of a good is determined by the willingness of a purchaser to part with other economic goods in order to receive it. While in modern times, most agents part with a certain amount of money in order to procure an economic good, money is by construction an object designed to facilitate economic barter. The real (as opposed to nominal/money) value of an economic good is essentially determined by the barter transactions possible for it. For example, a tonne of steel might be worth so many bushels of wheat. The point of this is that economic value is determined relative to other economic goods in the market, is not an absolute value, and is not fixed over time.


If the (relative) economic value of preserving our natural environment is anticipated to become greater in the future, it may follow that the actuarial net present value of tackling climate change rises, that the actuarial net present cost of climate deterioration also rises, and social substitution towards economic processes that do not adversely affect, or even improve the environment, increases. This may occur independently of the discount rate, as a consequence of changing social *preferences*.

John Roe said...

This is great - some real economic pushback. But I am not convinced. Is it really true, as is suggested, that a high rate of economic growth can be delivered without a high rate of increase in energy consumption? This is the "dematerialization" thesis - that the economy is somehow becoming increasingly detached from physical reality, and especially from fossil fuel consumption which is the final common pathway for nearly all present-day economic processes.

My "things being as they are", above, was meant to imply a certain skepticism towards this idea. Not only because I doubt that there is enough possibility of "dematerialization" to make a difference to the economy in general, but also because the kind of economic growth that would be needed to offset severe climate change would be of so obstinately material a kind. Heavy engineering, high-tech agriculture, mass migration? Try dematerializing that!

byron smith said...

Yes, if it is plausible that ecological issues (including, but not limited to climate change) are likely to have such a significant impact on the economy over the next few decades that growth ceases (over long time frames), then it may make good sense to analyse present risk-benefit analyses using a negative discount rate: that is, that a dollar/pound/yen/euro today is worth less than one in the future, and so future costs become even more significant than present ones.

But this also assumes that risk-benefit analyses are ethically desirable (or at least ethically neutral, which is what is usually claimed). I reject such a claim, since I question the ability to translate all goods into financial values, that is, I refuse to accept that everything valuable has a price tag. Many of the things threatened by climate change (and ecological degradation) are not easily priced: how much is a stable climate worth? How much the preservation of a species or ecosystem? How much is it worth to know that my grandchildren will not face a systematically more hostile world than our present one?