The future matters, so discount it with care.

rethink sustainability

The future matters, so discount it with care

Dimitri Zenghelis - Project Leader, The Wealth Economy, Bennett Institute, University of Cambridge

Dimitri Zenghelis

Project Leader, The Wealth Economy, Bennett Institute, University of Cambridge

Anyone familiar with project appraisal for infrastructure projects—investments which yield a return for many years or decades into the future—or, indeed, with managing their own savings will be familiar with the importance of discounting.

Discounting” is the process of defining the present value of a unit of consumption at some future date. The discount rate measures the reduction from one year to the next. Inappropriate discounting of uncertain, large-scale transformations can generate dangerous risks, disproportionately burden the poor and discriminate against future generations. To illustrate this, I use the approach adopted in the 2008 Stern Review on the Economics of Climate Change, of which I was an author.

Discounting is the process of defining the present value of a unit of consumption at some future date. The discount rate measures the reduction from one year to the next.

The Stern Review applied the Ramsey social discounting framework to assess future risks associated with runaway climate change. This is the workhorse tool in economics, yet it has been subject to extensive abuse.


Don’t bash the poor…

Frank Ramsey identified two reasons why economists and philosophers apply a discount rate to society’s future income. The first is simple. Future costs are ‘discounted’ because future generations will be richer and better able to afford them. This reflects the diminishing marginal utility of consumption, whereby losing a dollar matters more to a hungry person than to a billionaire. So, the argument goes, because future generations will be richer, they should hold a lower claim on current resources than poorer people today. In other words, it’s a utilitarian rationale for redistribution based on the principle that the rich get less ‘happiness’ from a dollar than the poor. 


…and don’t discriminate against your descendants

The second rationale behind Ramsey discounting is the passage of time itself. This is called the pure rate of time preference. It reflects individual impatience. Irrespective of whether they expect to be richer or poorer in the future, most people prefer jam today to jam tomorrow and, at some point, they expect to die so it makes sense that we, individually, discount the future heavily.

Why should we treat the well-being of current generations on an equal basis but apply a different treatment to the well-being of generations born next year, or the year after? 

But climate change is such a long-term social problem that it is inappropriate to use personal myopic preferences as the basis to determine policy. Why should we treat the well-being of current generations on an equal basis but apply a different treatment to the well-being of generations born next year, or the year after?

Economists understand this: Pigou; Solow; Keynes and Sen all rejected pure time discounting as arbitrary, holding no ethical basis for long-term public policy choices. Ramsey himself summed it up best when he judged pure time discounting as “ethically indefensible and arises merely from the weakness of the imagination.”

Yet some economists like William Nordhaus, co-recipient of the 2018 Nobel prize for economic sciences, think otherwise. Nordhaus argues that climate change requires only a modest action now, with a more significant response in future decades. This is partly because Nordhaus took his (inflation-adjusted) discount rates from observations derived from market interest rates which were “in the range of 3 to 6 percent per year.” This automatically downgrades the value of action to safeguard future generations: a 5% discount rate means a human life today is worth 130 in a century’s time. Quite a trade-off!

Yet some economists…argue that climate change requires only a modest action now, with a more significant response in future decades.
 

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This feels wrong and is wrong. A century of economic literature from Marshall and Pigou to Arrow and Mirrlees has recognised that using market rates to derive social preferences is misplaced. Except under implausible circumstances, including that all consumers today, and in the future, are represented. The decisions of those alive now should not decide social policy that will affect billions of lives not active in the markets.

The decisions of those alive now should not decide social policy that will affect billions of lives not active in the markets.

Future perfect

So how did the Stern Review apply the Ramsey tool?. For the first element in the approach, we accounted for lower marginal utility at a rate of 1% for every 1% additional consumption, a relatively common assumption. But here’s the important bit. Climate damages change the world and therefore changes the discount rate, and one of the key characteristics of the climate science is the uncertainty.

Climate damages change the world and therefore changes the discount rate, and one of the key characteristics of the climate science is the uncertainty.

So, we ran 1000 projections reflecting this uncertainty in the climate science and generated 1000 corresponding discount rates (there is no single ‘Stern discount rate’). Some forecast scenarios rendered people richer, but in some scenarios catastrophic events resulted in negative discounting giving poorer people in the future a greater weight.

For the second element, impatience, we agreed there is no ethical reason to discriminate by birth date. From an objective social point of view, people distant in time are no less deserving than people distant in space. However, we did account for existential risks whereby future generations may not exist at all making it inappropriate to value them on a par with the current generation (for example if humanity is wiped out by asteroid strikes or nuclear war). For this, we applied a 0.1 percent discount rate (this is not trivial as it implies a one-in-ten chance of not making it through a century and explains why we can avoid the problem of assessing the consequences of every decision equally for infinite future years). 

From an objective social point of view, people distant in time are no less deserving than people distant in space.

Other approaches have adopted similar reasoning to derive ‘certainty equivalent’ social discount rates that decline over time and in order to account for the fact that future outcomes are uncertain, as famously argued by Arrow and his colleagues  and Weitzman. These approaches offer an alternative way to capture risk and yield a similarly strong case for early action. 

Economists do care about the future.. and we will be responsible for building it.

Right tools for the job

We do care about the future, and as I argued here before, we will be responsible for building it. The two-step Ramsey procedure is a powerful part of the economics toolkit. Used appropriately, it makes a strong case for action on climate and sustainability.

If instead we had started with the assumption that humanity does not care about the future we would discount away most climate risks.

If instead we had started with the assumption that humanity does not care about the future we would discount away most climate risks. As with any powerful tool, discounting is useful if used appropriately and dangerous if not. It’s a bit like using a chain saw, only more perilous.

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