Those following U.S. climate policy will have run into talk of the “discount rate” this week. A discount rate, for those not in the know, is the flip side of an interest rate. Where an interest rate allows us to calculate how much something we have today (like money in the bank) will be worth in the future, a discount rate tells us how much something we will have in the future is worth to us today. The idea is that we prefer pleasure now to pleasure later (and pain later to pain now). Imagine, for example, that someone owed you $100 in a year. What’s the least you would accept now rather than wait a year for the $100? Supposing it is $90, then we say that your discount rate is 10 percent.
Many environmental economists, including me, are troubled by the use of almost any discount rate greater than zero to calculate the current worth of values (future benefits and harms) that will occur more than a generation from now – an issue of especially importance in climate economics. Here’s what all the kerfuffle is about: When used in long-term analyses of environmental impacts – climate change, the storage of nuclear waste, etc. – the discount rate quantifies our ethical judgment regarding the importance of the welfare of future generations (compared with our own). When we say that the discount rate is zero, we mean that we consider the health and well-being of future generations to be just as important as our own health and well-being. The larger the discount rate, the more we value our own lives and livelihoods over those of our grandchildren.
The current conventional wisdom calls for discount rate that is something like the short-term “risk-free” interest rate (3 to 5 percent) for calculating the worth today of values that will exist at sometime within the next 20 or 30 years, and slightly lower discount rates for values that will exist in the more distant future. The idea is that the interest rate on the safest investments is what people require to compensate them for waiting (getting their payment later, rather than now).
But people routinely put savings away at very low interest rates. To my mind, this strongly suggests that, even within a single generation, the discount rate can be very low. We save money because it will have a value to us in the future. That we’re willing to put it in savings accounts that often have a less than 1 percent annual interest rate after adjusting for inflation means that it’s worth it to us to put $100 away today to secure about $100 in the future. It would surprise us to hear that our neighbors – unable to find an investment with a 10 or 20 percent rate of return – chose to spend all their money today. We put money away because the future (our own, and that of our families) is important to us. That we can earn some interest on that money is just a side benefit.
Reasonable people can and do disagree about the most appropriate discount rate to apply to long-term problems, although the use of discount rates above 5 percent has become much more unusual in recent years, and a discount rate over 3 percent on values that will occur in 2050 or later certainly would raise the eyebrows of many (most?) climate economists.
That’s why reports last week – now said to be erroneous – that the Office of Management and Budget (OMB) was recommending discount rates of 25 or even 50 percent for use in environmental analyses got a lot of people in a lather (these outrageous rate recommendations are now said to have originated with a staffer in another agency and were posted online, but not advocated, by OMB).
Similarly, the Obama administration’s recommendation of a social cost of carbon based on a 3 to 5 percent discount rate, for an analysis that stretches hundreds of years into the future, puts a surprisingly low value on the next generations’ welfare. Here’s an example: An event with the magnitude of material damages of Katrina (which some estimates put at $300 billion) occurring 500 years from now would be worth just $110,000 today at a 3 percent discount rate, or $8 at a 5 percent discount rate. Personally, I think the future is worth more than that.