The Role of Discounting
EAERE annual conference, June 2008, Gothenburg, Sweden
Reyer Gerlagh, University of Manchester / VU Amsterdam
Philibert Cedric, Greg Hertzler, Michael Hoel, Snorre Kverndokk ,
Cees Withagen
and many others
and you
Institute for
Environmental Studies
Vrije Universiteit
Amsterdam
Reyer Gerlagh
EAERE, June 2008
1/18
Déjà Vu
• 2006/7, Stern et al.: BAU Climate change damages exceed mitigation costs by
magnitude. We need deep GHG emission cuts.
• Analysis based on almost-zero discounting for ethical reasons
• 2006/7, Toll & Yohe, Byatt et al., Nordhaus, Dasgupta: Almost-zero discounting is
nonsense.
• E.g., it implies huge savings of man-made capital, which is (i) unrealistic, (ii) bad for the
poor, (iii) polluting
• 2008, Dietz et al. (=Stern team): We stick to our conclusions and our methodology
Have we learned nothing since 1992 (Rio de Janeiro, UNFCCC)?
• 1992, Cline “The economics of global warming”: pure discount rate should be zero,
for ethical reasons.
• 1928, Ramsey: positive pure discounting reflects lack of imagination.
• 1994, Broome “Discounting the future”
• 1992, Nordhaus “An optimal transition path …”: pure discount rate should be 3%/yr,
otherwise policy is inefficient (=waste of income).
Institute for
Environmental Studies
Vrije Universiteit
Amsterdam
Reyer Gerlagh
EAERE, June 2008
2/18
The problem
• “After a century of promoting benefit–cost analysis using net present
values, some economists have lost faith. Net present value discounts the
long-term consequences of species extinctions, greenhouse gas emissions
and nuclear wastes to virtually nothing. This is unacceptable.” (Greg
Hertzler)
Institute for
Environmental Studies
Vrije Universiteit
Amsterdam
Reyer Gerlagh
EAERE, June 2008
3/18
Aim
• To help those of us who are confused by this seemingly lack of progress to
understand the alternative views, so that we can
• Appreciate literature on hyperbolic discounting, dual discounting, uncertainty,
etc.
• Move towards exchange of arguments, rather than merely stating positions
• Escape the battle between ‘zero’ and ‘positive’ pure discounting
• And make a more nuanced choice
Institute for
Environmental Studies
Vrije Universiteit
Amsterdam
Reyer Gerlagh
EAERE, June 2008
4/18
The Question
What is the role of discounting?
• Descriptive: to provide an consistent framework for inter-temporal efficient
decisions
• To ensure efficiency between policy decisions on different areas?
• Prescriptive: to provide a consistent framework for inter-temporal ethical
decisions
• To ensure equity between present and future generations?
And what does that imply for discounting principles?
• We will discuss collected propositions on
• discounting accepting the efficiency perspective (descriptive)
• discounting based on a more normative stand (prescriptive)
Institute for
Environmental Studies
Vrije Universiteit
Amsterdam
Reyer Gerlagh
EAERE, June 2008
5/18
Propositions Overview I: descriptive
Within the descriptive perspective, we need a more elaborate approach
compared to current practice
• It is rational to use dual discounting with low discount rates for
environmental assets that are not substitutable nor reproducible (Philibert
Cedric).
• Not discounting as such, but the risks and consequences of environmental
damage is important. We should use real option values (Greg Hertzler +
others).
• Even under perfect foresight, the Ramsey rule does not apply to the
aggregate-level and can’t be used for long-term discounting (Reyer
Gerlagh)
Institute for
Environmental Studies
Vrije Universiteit
Amsterdam
Reyer Gerlagh
EAERE, June 2008
6/18
Overview of Propositions II: prescriptive
It is not that simple to understand & represent inter-generational preferences
• The utilitarian perspective with almost-zero discounting is just one
(arbitrary) possibility to deal with intergenerational equity. Not necessarily
the preferred option (Nordhaus 2006).
• We should differentiate between intra-personal and inter-personal discount
rates (Michael Hoel).
• Consumers’ pure time preference is not exogenous, but depends on policy
(Snorre Kverndokk).
• It is rational to use dual discounting with market interest rates for short term
and ethical interest rates for long-term decisions (Reyer Gerlagh).
Researchers be more careful
• All long-term environmental analyses need substantial sensitivity analysis
with regard to the discount rate used (Cees Withagen).
Institute for
Environmental Studies
Vrije Universiteit
Amsterdam
Reyer Gerlagh
EAERE, June 2008
7/18
Proposition 1. Substitutability
• It is rational to use dual discounting with low discount rates for
environmental assets that are not substitutable nor reproducible (Philibert
Cedric).
Explanation
• Environmental assets that cannot be reproduced or substituted will become
increasingly valuable. Thus, giving them a value that would grow at a rate
slightly below the discount rate solves the problems that discounting
discounts environmental damages to zero.
• Literature: Neumayer 1999; Gerlagh and van der Zwaan 2002, Hoel &
Sterner 2007, Sterner and Persson 2008
Implication/importance
• If this proposal is accepted, “usual” discount rates would not anymore lead
to net present values of future environmental damages that seem
ridiculously low. The irreplaceable nature of Nature, and the irreversibility of
its destruction, would thus be taken in account.
Institute for
Environmental Studies
Vrije Universiteit
Amsterdam
Reyer Gerlagh
EAERE, June 2008
8/18
Proposition 2: Risk
• Much more important are the risks and consequences of environmental
damage. We should use real option values (Greg Hertzler).
Explanation
• We should not use a small discount rate. Instead, we need real option
values that include additional random processes, nonlinearities and
irreversibilities. In a world of uncertainty, real option values should replace
net present values in all benefit–cost analyses. Then we might adequately
invest to protect our future.
• Literature: Weitzman with fat tails 2007
Implication
• By truly taking account of the risks, the analysis becomes much more
complex, but such is necessary for a well-informed decision.
Institute for
Environmental Studies
Vrije Universiteit
Amsterdam
Reyer Gerlagh
EAERE, June 2008
9/18
Proposition 3: Aggregation (Ramsey rule exit)
• Even under perfect foresight, the Ramsey rule does not apply to the
aggregate-level and can’t be used for long-term discounting (Reyer
Gerlagh).
Explanation
• The Ramsey supposedly holds for an individual’s savings decision, not on
the aggregate level. There is not one representative ever-living consumer.
When tested empirically, there is no support that in the long-term economic
growth is the single most important fundamental determinant for changes in
the real interest rate. Demography, social security, and other variables are
probably as important as determinants.
• Literature: Howarth and Norgaard 1992, Gerlagh and Keyzer 2001,
Gerlagh and van der Zwaan 2001, Weitzman 2007
Implication
• If we follow the descriptive approach, we cannot apply the Ramsey rule
without admitting there is no empirical support.
Institute for
Environmental Studies
Vrije Universiteit
Amsterdam
Reyer Gerlagh
EAERE, June 2008
10/18
Summary Propositions 1-3
• When accepting the descriptive approach, we should not simply use the
Ramsey rule. We should (i) discount environmental assets that we don’t
want to loose at a lower effective rate, and (ii) make better assumptions on
possible paths for the future interest rates.
Institute for
Environmental Studies
Vrije Universiteit
Amsterdam
Reyer Gerlagh
EAERE, June 2008
11/18
Proposition 4: Arbitrariness
• The utilitarian perspective with almost-zero discounting is just one
(arbitrary) possibility to frame intergenerational ethics. Not necessarily the
preferred option (Nordhaus 2006).
Explanation (by myself)
• Assume we accept there is a problem: ‘descriptive’ discounting justifies too
high environmental damages. There is a technical solution: the utilitarian
perspective with almost-zero pure discounting. But this does not imply that
this is the best solution. In other policy arenas such as health, social
security, discrimination, it is not the utilitarian perspective that guides policy,
but other principles such as the right for help when health is considered,
the right not to have to live in poverty, the right to be treated equally.
Implication
• Other perspectives can offer other solutions. Do future generations have
the right for a ‘safe climate’ (precautionary principle), or the right to enjoy a
real rain forest? Valuing future welfare is not always needed.
Institute for
Environmental Studies
Vrije Universiteit
Amsterdam
Reyer Gerlagh
EAERE, June 2008
12/18
Proposition 5: Intra vs inter-personal preferences
• We should differentiate between intra-personal and inter-personal discount
rates (Michael Hoel).
Explanation (by myself)
• Within-person decisions on savings (pension, consumption smoothing)
drive (the interest rate on) the capital market (jointly with firm’s investment
requirements). People have preferences for intergenerational distribution
that are separate of their own savings, and thus, the preferred social level
for intergenerational discounting cannot be derived from markets.
Implication
• We should not copy market interest rates and apply them for climate
change policy. We should employ different methods to determine interpersonal preferences.
Institute for
Environmental Studies
Vrije Universiteit
Amsterdam
Reyer Gerlagh
EAERE, June 2008
13/18
Proposition 6: Education lowers discounting
• Consumers’ pure time preferences are not exogenous, but depend on
policy (Snorre Kverndokk).
Explanation
• Ramsey (1928) already wrote that discounting shows lack of imagination.
• People are more likely to be addicted if their time preference rate is high.
Becker and Mulligan (1997) assume that individuals can invest in goods or
activities, such as schooling, to reduce this rate and analyze the
implications. This insight broadens the set of instruments available to policy
makers, and it should be considered in a cost-effective climate policy. But is
it ethically right to influence somebody’s time preference rate? This may be
hard to answer, but a lower time preference rate increases the NPV value
of life and is considered to be to the benefit of the individual.
Implication
• Educational programs may form an effective part of climate change policy.
There are many other positive benefits to education, but this is an
unexpected extra. (also: rethinking the purpose of aid)
Institute for
Environmental Studies
Vrije Universiteit
Amsterdam
Reyer Gerlagh
EAERE, June 2008
14/18
Proposition 7: Dual discounting is rational
• It is rational for governments to use dual discounting with market interest
rates for short term and ethical interest rates for long-term decisions (Reyer
Gerlagh).
Explanation
• When the current government saves more (borrows less), the next
government can easily cash by lowering taxes and spending the savings.
No government can commit the next government to its long-term savings
plan (cf US). Lack of commitment implies a higher discount rate for public
savings decisions. When the government cuts emissions, the next
government cannot turn past abatement costs into current cash. Instead,
the benefits will surely reach the intended future generations. Thus, each
government can make its own decision on the true long-term preferences
without worrying about the intermediate governments (simplification).
Implication
• Given imperfect commitment, optimal policy may be dynamically inefficient
(dual discounting) when perceived from first-best, but still be time
consistent and optimal within institutional boundaries.
Institute for
Environmental Studies
Vrije Universiteit
Amsterdam
Reyer Gerlagh
EAERE, June 2008
15/18
Summary Propositions 4-7
• When accepting the prescriptive approach, we do not need to use the
Ramsey rule with an almost-zero pure rate of time preference. We should
(i) try to find out in what way people care about the far future, (ii) where
required accept different discount rates for different assets based on our
understanding of feasible policy commitment, and (iii) educate the people.
Institute for
Environmental Studies
Vrije Universiteit
Amsterdam
Reyer Gerlagh
EAERE, June 2008
16/18
Proposition 8: Sensitivity analysis needed
• All long-term environmental analyses need substantial sensitivity analysis
with regard to the discount rate used, including descriptive and prescriptive
discount rates (Cees Withagen).
Explanation
• Seems very much common sense, but watch out. The proposition states
that the sensitivity should involve both ‘descriptive and prescriptive
discount rates’.
• "Ignoring realities in adopting 'principles' may lead one to search for a
nonexistent optimum, or to adopt an optimum that is open to unanticipated
objections." (Koopmans 1965: On the concept of optimal economic growth)
Implication
• More information, but also confused policy makers?
Institute for
Environmental Studies
Vrije Universiteit
Amsterdam
Reyer Gerlagh
EAERE, June 2008
17/18
[Your Proposition]
• Suggestions for further discussion?
Institute for
Environmental Studies
Vrije Universiteit
Amsterdam
Reyer Gerlagh
EAERE, June 2008
18/18
Thank You
Institute for
Environmental Studies
Vrije Universiteit
Amsterdam
Reyer Gerlagh
EAERE, June 2008
19/18