Programs that aim to secure sustainable development, such as those advocated by the Stern Review of the Economics of Climate

Change or the United Nations Environment Programmes The economics of ecosystems and biodiversity: an interim report, maintain that a value must be placed on the future flows of costs and benefits economicenvironment interactions. Consider the case that economists make for setting particular rate at which these future costs and benefits should be valued.

All around the world, governments and various agencies are in the position of deciding whether or not to implement a certain policy, be it the building of a highway, an investment in healthcare or the preservation of a national park. In order to make this kind of decisions, governments have increasingly resorted to a particular economic tool: cost-benefit analysis. In this essay I will analyse one of the most thorny issues related to cost-benefit analysis, namely the selection of a rate at which we should discount future benefits and costs when evaluating environmental policies. I will commence with a short historical and theoretical introduction to costbenefit analysis, and will then proceed to present the two main schools of thought on the selection of discount rates: the prescriptive approach and the descriptive approach. While analysing the main critics to both approaches, I will touch upon the issues that arise when discounting at a positive rate. I will then present the argument for time-declining discount rates and finally conclude with a brief review of the actual discount rates used by various governments. The first to present cost-benefit analysis as a decision tool for policy makers was a French civil engineer, Jules Dupuit (On the Measurement of the Utility of Public Works, 1844)1. Further momentum was subsequently given by the the Federal Navigation Act of 1936 in the U.S., for which the U.S. Corps of Engineers have to weight benefits and costs of new projects and are required to carry out only those that provide positive net benefits to society2. Ever since, the importance of CBA in the policy arena has grown, making it the most widely used approach to assessing public investment3.

1 2

Turvani (2006) supra 3 Pearce et al (2006, p.16)

But what is CBA in practice? As defined by the Concise Encyclopedia of Economics, CBA is an attempt to identify and express in dollar terms all of the effects of proposed government policies or projects4. The outcome of this process can be summarized through the Net Present Value:

The Net Present Value is the sum of the discounted differences between benefits and costs deriving from the project that would occur at each year t. In general a positive NPV suggests that the policy under analysis will yield net benefits to society while a negative NPV implies that society will be made worse off. This apparently simple approach in reality conceals complex issues, such as assigning a monetary value to commodities that do not carry a market price. This is in particular true when we monetize the benefits of a particular environmental policy: for instance, how much is the prevention of global warming worth? Furthermore, assuming we know the dollar value of preventing an increase in temperatures in a few decades, how much is that benefit worth now? What discount rate should we use to find the present value? There is no unambiguous answer to this last question and economists resort to different procedures. We can identify two main approaches on how to select a particular discount rate: the prescriptive approach and the descriptive approach. The former consists in determining what discount rate should be applied based on ethical arguments, while the latter focuses on the actual discount rate society applies on a day-to-day basis to decide among different investments5. The prescriptive approach is therefore based on what we ought to do from a moral perspective, while the descriptive approach is based on what we actually do. If we adopt the prescriptive (or normative) approach, as for example the Stern Review does, the social discount rate is calculated through the formula: r=+g where is the pure rate of time preference, which reflects peoples impatience, is the marginal utility
4 5

Portney (2010) IPCC (2007, chapter 2, p. 136)

of consumption (the percentage change in welfare derived from a percentage change in consumption), and g is the rate of growth of GDP per capita6. This formula is often referred to as the Ramsey formula from the economist that first presented it in 1928. It is the point of departure of what many define an ethical approach because the parameter reflects moral judgements on intergenerational equity: given the fact that the benefits of an environmental-friendly policy often accrue to future generations, this parameter reveals how much we value the welfare of future generations. If we treat each generation equally, so that for example clean waters for those yet to be born are worth the same as clean waters for the present generations, this parameter would be close to 0%. For example, in the Stern report g is on average 1.3% per year, is 1 and is 0.1%, resulting in a recommended social discount rate approximated to 1.4%. Such a low value for is derived from the ethical consideration that only the small chance that society will not exist should be taken into account, while pure impatience should not7. This approach is criticized by the descriptionists, who instead argue that governments should take into account individual preferences as reflected by societys actual choices. The proponents of the descriptive approach therefore call for a discount rate based on the market return on capital. The use of market interest rates is based on efficiency criteria and in particular on the concept of opportunity cost: when evaluating a certain policy, we should compare the benefits it produces to the returns that would proceed from an investment in the private sector8. The descriptive approach aims at maximizing the welfare of current and future generations by selecting the policies with the highest rates of return. The discount rate should therefore only reflect the efficiency criterion, and other ethical analyses should be performed separately9. In general, the discount rates calculated through the descriptive approach are higher than those calculated through the prescriptive approach10 and the lower the discount rate, the higher the weight of future generations in cost-benefit analysis. For example, a project that costs $10,000 today and would benefit society in 90 years by avoiding environmental damages of $1,000,000 would have a positive NPV if we apply a discount rate of 5%. If, instead, we apply a discount rate of 8%, the NPV would turn out to be negative and the project would not be carried out. Using a higher discount rate can therefore lead to outcomes that seem inconsistent with the notion of intergenerational equity. This line of
6 7

Pearce et al. (2006, pp. 187-188) Stern (2007, pp. 47-48) 8 Harrison (2010, p. 12) 9 Scheraga et al. (1998, p. 4) 10 Hepburn (2009)

reasoning has induced, among other economists, Pearce to expose the tyranny of discounting11. On the other hand, using a discount rate close or equal to 0% also has potential drawbacks, as it may lead to a tyranny of the future generations12. As Pearce goes on to argue, a 0% discount rate may harm future generations by displacing capital that would have yield higher returns and thus higher future consumption if invested in the private sector. Furthermore, it implies that each generation would be impoverished as consumption is sacrificed to make future generations better off in a neverending cycle13. An interesting standpoint regarding the tyrannies of discounting and not discounting has been proposed by Weitzman. In his words to think about the distant future in terms of standard discounting is to have an uneasy intuitive feeling that something is wrong, somewhere. The logic of exponential discounting forces us to say that what we might otherwise conceptualize as monumental events do not much matter when they occur in future centuries or millennia. To resolve this issue Weitzman calls for a discount rate that converges to 0% as the time periods extends to infinity14. Other economists support the use of time-declining interest rates on various theoretical grounds, such as the uncertainty of future discount rates (Weitzman, 1998) and economic growth (Gollier, 1997), intergenerational fairness and empirical results on the actual individual choices of discount rates15. These strong arguments behind time-declining interest rates have in particular induced the governments of France and the UK to employ them in cost-benefit analyses16. However, this approach is not flawless. It has been criticized on grounds of time-inconsistency: as preferences change at different points in time, future generations might deviate from the policy chosen by the current government. If this is the case, it is possible that the current strategy is not an optimising behaviour17. The divergence of opinions among economists on what social discount rate should be used is reflected in the disparity of discount rates applied by individual countries: the Philippines apply a discount rate of 15%, Pakistan of 12%, Canada of 8%, the European Union of 5% and Germany of 3%18. It is interesting to notice how the highest rates are applied by developing countries, fact that reflects the higher opportunity cost of capital.
11 12

Pearce et al. (2003, p. 123) Harrison (2010, p. 20) 13 Pearce et al. (2006, pp. 124-125) 14 Weitzman (1998, pp. 201-203) 15 Pearce et al. (2006, pp. 126-131) 16 Rambaud at al. (2006) 17 Pearce et al. (2003, pp. 133-134) 18 Zhuang et al. (2007, table 4, pp. 17-18, 20).

Notwithstanding the multiplicity of discount rates employed, one common trend is that of a decline in the discount rates applied by many agencies19. This raises the hope that such a tendency reflects an underlying increasing concern and respect for the environment and a higher sense of intergenerational fairness.

Words count: 1499

19

Harrison (2010, p. 12)

References

Cruz Rambaud, Salvador, and Mara Jose Munoz Torrecillas. "Social Discount Rate: A Revision." Anales De Estudios Economicos Y Empresariales XVI (2006): 75-98. Harrison, M. 2010, Valuing the Future: the social discount rate in cost-benefit analysis,Visiting Researcher Paper, Productivity Commission, Canberra. Hepburn, Cameron. "Ethics and Discounting Global Warming Damages." Resources for the Future. 30 Oct. 2009. Web. <http://www.rff.org/Publications/WPC/Pages/Ethics-and-Discounting-GlobalWarming-Damages.aspx>. "IPCC Fourth Assessment Report: Working Group III Report "Mitigation of Climate Change"" IPCC Intergovernmental Panel on Climate Change. 2007. <http://www.ipcc.ch/ipccreports/ar4-wg3.htm>. Pearce, David, Ben Groom, Cameron J. Hepburn, and Phoebe Koundouri. "Valuing the future: recent advances in social discounting" World Economics 4.2 (2003): 121-141. Pearce, David, Giles Atkinson, and Susana Mourato. Cost-benefit Analysis and the Environment Recent Developments. Rep. OECD, 2006. Portney, Paul R. "Benefit-Cost Analysis: The Concise Encyclopedia of Economics." Library of Economics and Liberty. <http://www.econlib.org/library/Enc/BenefitCostAnalysis.html>. Scheraga, Joel D., and Frances G. Sussman. Discounting and Environmental Management. Tech. International Yearbook Of Environmental and Resource Economics, 1998. Stern, Nicholas. Stern Review on the Economics of Climate Change. Rep. Cambridge UP, 2007. Turvani, Margherita. Cost-Benefit Analysis: a Policy Evaluation Tool in an Historical Perspective. Department of Urban Planning, Universit Iuav Di Venezia. Weitzman, Martin L. "Why the Far-Distant Future Should Be Discounted at Its Lowest Possible Rate." Journal of Environmental Economics and Management (1998). Zhuang, J., Liang, Z. Lin, T. and De Guzman, F. 2007, Theory and Practice in the Choice of Social Discount Rate for CostBenefit Analysis: A Survey, Asia Development Bank