One of the central difficulties in attempting to avoid climate change is the long-term and multi-generational nature of the problem. The current generation is required to incur large investment costs today which will most likely only yield benefits for future generations as a result of the gradual rate at which GHG emissions concentrations rise and the long-lived nature of some GHG emissions like CO₂ [i]. There is thus a tension between current and future interests. This presents a problem to decision makers as Cost-Benefit Analyses (CBA), used to make investment decisions between potential alternative mitigation projects, require the stream of future benefits and costs to be compared at their discounted present values[ii]. This necessitates the use of a discount rate, the choice of which has a significant impact on the kinds of projects that will seem justifiable to the current generation and thus what kind of world future generations inherit[iii].

The economic theory behind discounting future values rests on three premises. The first is that people hold pure time preferences, which means they will choose smaller consumption today over slightly larger expected consumption in the future due to the inherent risk of future consumption. In other words, you would rather accept R100 today than R101 next week because there is some possibility you might get hit by a bus before next week and not be able to enjoy the R101. The second premise rests on the assumption that economic growth will lead to future people being richer than people today. Therefore, future people will enjoy each extra unit of consumption less than people today would due to diminishing marginal utility (for most goods you get more enjoyment from the first unit than from the nth unit)[iv]. The final premise for discounting is the opportunity cost argument. If a person was offered R100 today and R103 rand in one year, they will rationally choose the R100 today if the market rate of return is greater than 3% because they could invest the R100 today and gain more than R103 in a year’s time. Therefore, the discount rate should match the market rate of return as this represents the opportunity cost of delaying consumption[v].

The formula used to calculate the present value of future values using a discount rate is shown below in equation 1):

The main debate in terms of the choice of discount rates is between those who propose low discount rates (generally below 2%) and those who propose discount rates in line with the rate of return in the market (generally above 5%). To understand the tension between these two schools of thought, consider a simple illustrative example where society must choose between mitigating the negative consequences of two problems: one immediate and one more long-term. Figure 1 shows the annual costs to society under each of these two scenarios over a 100-year time period.

Figure 1 Annual Costs to Society for an Immediate problem and a Long-term problem over 100 years

Source: Author

In the example above, the Immediate Problem imposes early costs on society, with its annual costs peaking 14 years from now, in the year 2030, and then linearly reducing. This problem could be analogous to that of a major financial crisis that slowly self-corrects over time without any intervention. However, the Long-term Problem grows slowly at first, yet with its annual costs to society increasing at an increasing rate. This situation is analogous to climate change.

If resources were needed to be diverted to mitigate one of these problems, the government would use a CBA to determine which problem imposes the greatest cost on society and then invest in efforts to mitigate that problem.

Using a discount rate of 5%, the present value of the Immediate Problem is -R55269, while the present value of the Long-term Problem is only -R12932. This entails that the Immediate Problem should be prioritised for action. However, when one looks at the present value of these Problems using a discount rate of 1%, then the present value of the Immediate Problem is -R106878 while the present value of the Long-term Problem is -R113 375, which would entail that the Long-term Problem should be the priority. The importance of the discount rate in determining which project should be chosen is thus clear. Higher discount rates may exaggerate the importance of costs or benefits that occur sooner in time and neglect significant costs or benefits that occur later.

Sunstein & Weisbach summarise the arguments of the two sides of the debate. On the one hand, proponents of zero or low discount rates (the ethicists) believe that intergenerational neutrality should be upheld. Proponents of higher discount rates (the positivists), however, hold that market-determined discount rates are necessary in order to efficiently choose between projects. The authors conclude that the argument has essentially been over two separate issues: distributional justice and efficiency. They state that discounting should only be used in order to make the most efficient project choice and not as a method of deciding the distributional justice of the current generation’s obligations to future generations.

However, to me it is unclear whether the issues of distributional justice and the efficient choice of projects can so easily be separated. In the example shown in Figure 1, the ‘efficient’ choice of project based on a market-related discount rate of 5% would be the project to mitigate the impacts of the Immediate Problem. However, this would result in the generations that live from 2076-2116 actually incurring greater annual costs, when they occur, than those that ever would have been faced by previous generations under the Immediate Problem. This consequence may be ethically dubious. Especially considering that if we look at the total undiscounted costs imposed over the 100 years under each problem scenario, the Long-term Problem results in aggregate costs in the order of 1.4 times greater than the Immediate Problem. Arguably, an all-knowing social planner shouldhave time horizons of at least 100 years and thus should not make the same decisions over this time frame as an individual would. The inherent time-scales of individuals and society are not the same and thus for social problems, a lower discount rate should be used. Say for example that we had two individuals, one with a life expectancy of 80 years and another, who represents society, with a life expectancy of 300 years. It would be natural that the individual with the higher life expectancy will discount the future at a considerably lower rate. If Figure 1 instead represented the cost implications of two problems during the course of one day for an individual, they would most likely choose to avert the Long-term Problem. Perhaps that is the same way that social planners should view longer periods when considering social problems. Furthermore, zero (or low) discount rates support the underlying logic of the sustainability movement, wherein longevity and cyclical relationships are emphasised over the short-termism and infinite-growth-in-a-finite-world doctrine of the traditional economic model.

Proponents of larger positive discount rates may respond by alluding to the three premises on which discounting is based: pure time preferences; economic growth considerations; and the opportunity cost argument. In what follows, I will attempt to show that these considerations are invalid in the context of climate change.

Pure time preferences

Pure time preferences are only relevant for discounting decisions made by individuals with an inherent probability of dying. Social discount rates are to be used for decisions involving the future of societies and the rate of time preference is only one term in this calculation (along with the elasticity of social marginal utility of consumption and the growth rate of consumption, dealt with below). The rate of pure time preference in the social discount rate should be close to if not equal to zero in order to represent the low probability that society itself will cease to exist in the future time horizon of a few hundred years[vi]. Indeed, the British economist and philosopher, Frank Ramsey, acknowledged the fact that private agents discount the future, yet said it would be ‘morally indefensible’ for governments to do so in social appraisals[vii].

Economic growth

Some positive discount rate could be defensible if we consider that economic growth will lead future generations to be more wealthy than the current generation. If this is the case, then the discount rate could be equal to the long-term expected economic growth rate[viii].

However, economic growth cannot merely be assumed to be capable of increasing without limit, and per capita growth rates should also take into account capital depreciation and population growth which could significantly reduce expected growth rates[ix]. Furthermore, the increasingly harsh impacts of climate change itself could slow economic growth through the destruction of capital and the reduction of ecosystem services[x]. A recent study found that the effects of climate change could cause ‘average income around the world [to be] 23% lower in 2100 than it would be without climate change’. Low future economic growth rates could also prevail if traditional economic indicators of national well-being, such as Gross Domestic Product (GDP) and Gross National Product (GNP), are augmented to include natural capital as advocated by Voora & Venema (2008)[xi]. If natural capital is included in these measures, then any environmental extraction or degradation is counted as a loss of national value; the global rate of loss of the environment would thus necessarily reduce growth rates.

Sunstein & Weisbach (2008) concede that uncertainty over which discount rates to use and long time horizons can make the effective discount rate tend to very low levels. This is because uncertainty over what the long-term market rate of return will be causes the bad possible states of the world, no matter how unlikely, to dominate the rate estimate in the averaging process. In other words, determining the expected discount rate is not merely a function of finding the average of all possible discount rates, but rather finding the average of the possible present values and then averaging this number to find the effective estimated discount rate, which increases the significance of low discount rates.[1] This observation is made more powerful given the evidence outlined above that the bad states of the world are not as unlikely as they were once perceived to be.

Additionally, it is not necessarily true that those paying for climate change mitigation will be the main benefactors of reduced climate change impact. It is the industrialised nations who shoulder most of the responsibility for climate change and they should thus incur most of the present value cost to mitigate the impacts of climate change. However, numerous evidence shows that the impacts of climate change will most heavily fall on the world’s poorest nations[xii]. Therefore, those who would benefit most from climate change mitigation would be the poorer countries who might not match the current wealth of those countries paying for mitigation, even if they do experience economic growth in the long term. This implies that income growth of future generations cannot a priori be assumed as a basis to justify positive discount rates.

Philibert (2003)[xiii] touches on this argument, but he concludes that this is no reason to discount the future at a rate of zero because investments into climate change mitigation should be considered relative to the opportunity cost of investing in development projects to spur economic growth. This leads to my next point.

For example, would it be worth spending $100 million now to avert a catastrophe that would cause $50 billion of damage in 100 years? If the discount rate were 8 per cent it would not — the future damage has a present value of $23 million, less than the cost of averting it… The logic of rejecting the catastrophe prevention is that if society received a rate of return of 8 per cent on money in the private sector, $100 million dollars would grow to $220 billion in 100 years, more than enough to compensate for the catastrophe (p. 18)

However, this line of thinking misunderstands the nature of the climate change problem. Apart from the many problems with quantifying and monetising the value of environmental goods and services, this argument does not take into account delays in atmospheric systems and the irreversible nature of many climate change impacts.

The effects of GHG emissions are durable and cumulative. Some emissions released into the atmosphere now will remain there for centuries and climate systems are slow to react to increases in GHG concentration levels, meaning that people many years from now will pay for the increased warming of today’s emissions[xv]. The impacts of climate change, and indeed the degradation of most ecosystems, cannot therefore be mitigated instantaneously. Action is thus required immediately to mitigate future negative consequences which might not be able to be avoided in the future, when CBA analyses eventually render the mitigation of the problem cost effective, due to the lagged response of natural systems.

The second problem is that the outcomes of investing in mitigation and making a counterfactual investment into capital markets are not commensurable. Mitigating climate change now results in functioning ecosystems and environments conducive to human life in 100 years, whereas investing $100 million into capital markets results in $220 billion in 100 years. It might not be possible to take that $220 billion and use it to compensate future generations, as the impacts of climate change can be irreversible especially once we pass climate thresholds. No matter how much money we have, we will not be able to bring back extinct species with inherent quasi-option value[2][xvi]. Therefore, inaction could lead to a future which is cash-rich but environment-poor and the $220 billion will have to be distributed between refugees displaced from no longer existing island nations; those in hunger due to mass crop failure; and those lucky few living in societies where some basic ecosystems services, historically free, are being provide by machines at a cost.

Sunstein & Weisbach argue that proponents of zero discount rates are conflating discounting welfare with discounting money. But is this necessarily true? The costs of climate change are inherently non-monetary and directly impact on welfare in perhaps the most fundamental of ways. Therefore, when we monetise these costs and discount them, it seems unavoidable that we are exactly discounting future welfare, or at least our willingness to pay for future welfare. The problem stems from the conceptual incongruence of finite natural capital and infinite market capital. Natural capital such as the atmosphere does not grow, thus there is no atmosphere bank in which we can invest pristine atmosphere and gain an annually increasing levels of atmosphere like we can with market capital.