Climate Change - the Stern Review and Discounting the Future

David Evans of Oxford Brookes University looks at an issue that has been the source of much controversy since the appearance of Sir Nicholas Stern’s review of the economics of climate change.

Other articles on this theme published in the Newsletter include:
The treatment of economic issues by the Intergovernmental Panel on Climate Change (Jan 2005)
More on the Intergovernmental panel on climate change (April 2005)
Nicholas Stern’s Immaculate Conception (July 2006)
Climate Change, Ethics and the Economics of the Global Deal (January 2008)
Letter from America - on transatlantic vices (October 2007)
Climate Change and its Mitigation (April 2013)

The Stern Review on the economics of climate change calls for decisive and immediate action to limit greenhouse gas emissions because the enduring long-term benefits of doing so clearly outweigh the costs. To an important extent this conclusion depends on the incorporation of what many see as an unreasonably low discount rate in the welfare model used to compare alternative policy options. In this article, I wish to focus on the discount rate issue in order to assess how far the criticisms of Stern’s low rate are justified and to what extent Stern’s response to the critics is appropriate. The most controversial aspect is the application of an extremely low pure time discount rate (p) which, after allowing for negligible catastrophe risk, is consistent with an ethical stance that weighs the welfare interests of present and future populations equally in relation to major global policy decisions taken ‘today’.

Many economists object to the ethical stance imposed in the model and have suggested that we should, to some extent at least, be guided in this matter by market rates of interest. They argue that market rates are considerably higher than the low discount rate used by Stern. For example, in Deaton’s article in the October 2007 Newsletter there is reference to a benchmark bond rate of 5 per cent.1 However, this is a nominal rather than a real rate, so the relevant rate for comparison should be at least 2 percentage points lower (lower still if post-tax returns are considered). A real rate of 3 per cent is lower than the official social discount rates of 3.5 per cent and 4 per cent applied by the British and French governments, respectively, in standard cost-benefit analysis (CBA).The trouble with using market rates is deciding which particular rates are most relevant and then trying to decide how much they are distorted by market imperfections, for example the market power of financial institutions in the retail financial markets and the differences between saving and borrowing rates. In any case, the evidence from bond markets does not seem seriously out-of-line with some countries’ official social discount rates and, moreover, can only offer a guide to appropriate discounting over periods of up to 30 or 40 years ahead. In relation to social time preference considerations spanning many generations, which are relevant in the case of very long-term policy options and projects, market rates of interest are not appropriate.

In reply to criticisms concerning the choice of discount rate, Stern made it most clear that for ordinary long-term social projects with investment horizons of up to 30 years, the social time preference rate (STPR) of 3.5 per cent set by the British government is appropriate. Indeed, his treatment of the decline in marginal utility with economic growth along a particular policy option path (for example, ‘taking no action on climate change’) is entirely consistent with Treasury guidance. However, the choice of pure time discount rate (p) is very different and the extremely low value selected is to a large extent responsible for the low discount rate applied in the model. Furthermore, it is this low value of p that is so important when it comes to assessing the welfare impacts of alternative policy options.2

Why is it that Stern can sanction the relevance of a pure time discount rate of 1.5 per cent in the appraisal of ordinary long-term social projects in the UK but insists on the relevance of a trivial rate of only 0.1 per cent in the very long-term global climate change model? First of all, the 1.5 per cent rate includes an element covering the pure time preference of individuals (or their elected representatives) due to factors such as impatience and myopia (0.5 per cent). Stern argues that while this is a relevant consideration for individuals within their own lifetimes, and thus relevant in the appraisal of ordinary long-term projects, it has no relevance to inter-generational issues. This has to be seen as a controversial viewpoint since there are issues here concerning an individual’s time preference for his or her own consumption as opposed to preferences expressed for the wellbeing of society as a whole, most obviously through government policy. The Stern Review is very clear on its ethical stance concerning inter-generational equity; the welfare of all generations should count equally and, as such, pure time preference should be set at 0 per cent. Such a view is in keeping with the thinking of Ramsey and other British economists but there are many others who would claim higher rates are relevant, with most selecting figures somewhere in the range 0-2 per cent.3 These alternative viewpoints are certainly credible and indicate varying ethical stances on matters concerning inter-generational equity.

A particular problem with respect to the rather disparate views on appropriate values for the pure time discount rate, is that it is by no means clear whether some of the opinions expressed are referring to pure time preference alone or also to ‘life chance’ or ‘catastrophe risk’. The British pure time discount rate of 1.5 per cent is mostly made-up of catastrophe risk, set at 1 per cent. So, while Stern argues somewhat controversially against the inclusion of a pure time preference rate, he admits to the relevance of catastrophe risk. Why then is this set at only 0.1 per cent rather than 1 per cent? On this matter, the argument put forward is only partly convincing. Stern agrees that for ordinary projects a rate of 1 per cent is defensible because the catastrophe risk in question relates to the possible elimination of all project returns through destruction of capital and technological obsolescence. However, in relation to major global policy options that impact on many future generations, catastrophe risk is seen in terms of cancellation of all welfare impacts due to the occurrence of a devastating event that eliminates the human race. This is the most extreme stance possible on catastrophe risk, even disqualifying disasters like the ‘Black Death’ from consideration, and it would not be unreasonable to take a less extreme position. In short, there is clearly scope to raise the value of the pure time discount rate in the Stern model both in relation to catastrophe risk and also by introducing a positive rate of pure time preference.

In recent articles in the Journal of Economic Literature (vol. XLV, September 2007) both Nordhaus and Weitzman argue that a discount rate as high as 6 per cent may be relevant as opposed to the extremely low rate of 1.4 per cent recommended by Stern.4 They argue that this much higher rate is at least consistent with observable market savings behaviour. In his modelling of alternative discounting strategies, Nordhaus shows that a more cautious approach on climate change mitigation policy may still be appropriate even if a near zero pure time discount rate is employed. This conclusion rests on the incorporation of a higher value for the elasticity of marginal utility of consumption (e) in the overall discount rate (STPR).5 Weitzman’s article draws attention to the importance of uncertainty in the discount rate, so that even if we entertain the idea that the relevant rate could fall anywhere in the wide band 1.4 - 6 per cent, over time the certainty-equivalent discount rate will gradually fall towards the bottom of this band. This influence of uncertainty raises the possibility at least that Stern is more correct on global climate change mitigation policy than many critics believe but for essentially the wrong reasons. However, such a possibility does to an important extent depend on all values in the band being considered equally likely rates and it appears to be the case that most economists are much more sceptical about the very low rates.

Developed countries can better afford the ‘insurance costs’ associated with the implementation of climate change mitigation policies. For countries with strong and urgent economic development agenda, such as China, India and the new member states in the European Union, there is good reason to weight the welfare interests of the present generation more heavily than those of future generations. Impatience for development ‘now’, as opposed to ‘later’, justifies the application of a higher pure time discount rate (p). So, given all the aggregation and averaging in the welfare model described by Stern, it seems reasonable to take an average position with respect to economists’ differing opinions on the appropriate value of p. A range of 0-2 per cent would largely cover these views. In fact, allowing for uncertainty in p would justify the application of a present value weighting of about 45 per cent to the projected environmental impacts in a hundred years time.6 This outcome represents a reasonable ‘average ethical stance’ given the aforementioned averaging and aggregation in the Stern welfare model. In fact, more than a few important welfare issues, including social affordability concerns, are conveniently hidden from view in this aggregation but discussion of these matters I will leave to others.

Notes:

1 See A Deaton, ‘Letter from America - On transatlantic vices, or Stern in America’, Royal Economic Society Newsletter (139), October 2007, p4.

2 For brief comments on the importance of the context in which discount rates are being applied, see N Stern, ‘Climate Change, Ethics and the Economics of the Global Deal’, Royal Economic Society Newsletter (140), January 2008, p11.

3 See M Spackman, ch 11 (pp 260-261) and D Evans ch 12 (pp 282-284) in M Florio (ed) Cost-Benefit Analysis and Incentives in Evaluation: the Structural Funds of the European Union, (Cheltenham UK: E Elgar, 2007).

4 The two Journal of Economic Literature articles are: W D Nordhaus, ‘A Review of the Stern Review on the Economics of Climate Change’, pp 686 - 702 and M L Weitzman, ‘A Review of the Stern Review on the Economics of Climate Change’, pp 703 - 724.

5 Nordhaus assumes a value of 3 for e in this particular case. However, much of the empirical evidence on this component of the STPR suggests the relevance of a considerably lower value; see M Spackman (ch.11, pp 262-265) and D Evans (ch.12 pp 285-291), loc cit.

6 See D Evans (2008), ‘Social Project Appraisal and Discounting for the Very Long Term’, Economic Issues (13), Part 1, pp 61-70.

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