Climate Change and the Discount Rate

The world we live in today is extremely connected, not only across the globe but also through generations, so that the decisions we make today affect our future lives as well as the ones of the generations after us. The most obvious example that comes to mind is the environment, our behaviour today has serious implications on how (and maybe even if) future generations can live. Completely ignoring here that there are people still disputing the role of humanity in climate change, in many cases, economists have to figure out how to incorporate this intergenerational connection into their analysis. This is where discounting enters the stage.

Many of you have maybe heard the ominous term “cost-benefit analysis” before, which basically means when you are trying to decide whether to go ahead with a project or not, add up all the costs and benefits, and proceed if the benefits outweigh the costs. That sounds easy enough, but when it comes to actually doing it there are some obstacles in the way. One of these obstacles is exactly what I’ve been talking about, how do we value costs and benefits that accrue not today, but maybe five, or ten, or even a hundred years in the future? The standard argument goes that consumption today is valued higher than consumption in the future, for two reasons; time preference and elasticity of the marginal utility of consumption.

The first reason – time preference – stems from the idea that we prefer consumption now rather than in the future. Eating the chocolate bar right now gives me more utility (~happiness) than waiting excruciating 24 hours and eating the chocolate bar tomorrow.  This has something to do with our preference for certainty, there is some uncertainty attached to my waiting a day to eat the chocolate bar; one of my roommates could eat it, I could lose it, or maybe I somehow develop an allergy to chocolate within the next day. These scenarios are more or less likely, but regardless of that, I don’t have to deal with any of these uncertainties if I eat the chocolate right now.

The second reason economists assume that consumption today should be valued in higher monetary terms than consumption in the future is that we will be richer in the future, so total costs that might seem high today will appear smaller the richer we get. This is based on the – reasonable – assumption that income will keep rising like it has been over the past few decades. The richer we get, the less we care about an additional unit of wealth – this is the concept of diminishing marginal utility. I value an extra £10 higher when I’m broke than when I just got a pay-check.

These two assumptions flow into what is called the discount rate, which is a factor by which we multiply all benefits and costs that accrue in the future and thereby convert them into their present value – what we would value them today. As per usual in economics, this is a simplification of reality, these assumptions don’t claim to hold for every individual at every point in time, but rather reflect an average trend for society.

This type of simplification is necessary and often useful, but in the context of environmental cost-benefit analysis, I have been struggling to wrap my head around this. When we are talking about climate change, surely, the costs of climate change, or conversely, the benefits of reducing emissions for example, are worth as much today as they are in the future.
The problem here lies with the conversion of everything (and I mean literally everything) into monetary terms. Even environmental goods such as a lake, a park or a wetland are tagged with monetary values so they can be included in the cost benefit analysis. Take a project to build an office building where there was a green space before. If you were to do a cost benefit analysis you would add up everything that is already in monetary terms such as costs for construction, materials, labour, etc. and benefits in terms of jobs created, additional revenue and so on. But you’d also identify costs and benefits that are not expressed in monetary terms such as the utility people get from the green space, what the green space does for air quality, disutility from traffic jams because people have to get to work at the same time and are all going to that office building and so on.

The environment is generally something that isn’t traded in a market place so economists had to come up with fancy ways of transforming the utility we get from environmental resources into monetary terms to include it into cost benefit analysis. Of course, there are objections to doing this based on the idea that you just simply can’t put a price on nature and yes, in an ideal world people would automatically value and respect the environment, but sadly we live in a capitalist society. While it is difficult to put a price on environmental goods, environmental valuation is a step of integrating something important (the environment) into a system that is flawed but already there.

It is a matter of fact that we communicate value in prices and to me, environmental valuation is a necessary evil in getting people to care about the environment. And for single, specific, projects this works out fine, but when we are talking about climate change the combination of environmental valuation and discounting dilutes the costs of non-action too much. The effects of climate change transcend borders and generations, it is an accumulation of many projects rather than a single, defined, undertaking. Environmental valuation is incredibly difficult, because there are some things you could never replace with any amount of money in the world, and a functioning ecosystem is an example of that. So already in the first stage of cost benefit analysis on climate change, we’d undervalue the environment, because environmental valuation simply cannot capture everything. When we then apply a discount rate that suggests that future generations will value these benefits lesser (or conversely can better deal with the costs), we undervalue our ecosystem even more.

Admittedly idealistic, I think the environment shouldn’t be discounted, because the uncertainty connected to climate change makes it difficult to determine the exact breaking point after which the apocalypse starts and the earth has finally had enough, and to be honest, I’d rather cut back on consumption, redefine the prices we put on goods such as water and meat, and overvalue the environment (you know, “just to be safe”) than discount and leave the next generation with even less than we have now.

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