The Choice of Discount Rate

There are three types of capital investments: Those that have a net economic cost, those that are costless and those that yield a profit. Mobilizing private capital is not different: it can be costly, costless or profitable. How much money should be invested in climate change mitigation or in mobilizing private capital for climate change mitigation partly depends on the discount rate. Discounting converts the (full) values of the impacts that occur at different points of time into common units, for example, translating the costs of future climate change damages into '(...) equivalent values in today's monetary units'.8

The application of discounting in environmental policy has long been controversial.9 In the climate area, the basic fault line runs between the

6 Gore was awarded Noble Prize (along with IPCC) in 2007.

7 IEA 2006a.

8 Goulder and Stavins 2002, 674.

9 Weitzman 1994.

sceptics who want to apply a similar discount rate as in any standard public investment decision, and the supporters who prefer to use a low or zero discount rate. Applying a discount rate means that damages, which are expected to occur in the long-term future have a very low present value, even if a reduced discount rate of 3 or 4 per cent is applied. Since the costs associated with climate change may peak in 50, 100, or more years, the discount rate methodology tells us to pay very little now to avert these damages.10 The higher the discount rate, the lower the investments we are willing to make today.

William Cline argues that people '(...) who prefer discount rates of 10 per cent can (...) dismiss global warming 100 years from now, because however catastrophic it might be, it is worth only a few dollars today to try to avert it'.11 A lack of willingness to pay for climate change mitigation is particularly problematic if it turns out that climate change impacts are cataclysmic, matching or exceeding worst case scenarios. The report of the IPCC confirmed the possibility of 'discontinuity scenarios',12 in which GHG emissions shoot above an upper limit, leading to further disasters. According to Innovest, 'The experience of the insurance industry shows that even small changes (<10 per cent) in event severity can generate multiple increases in damage.'13

The discount rate is controversial because it means to place a greater value on current relative to future lives.14 Nobel Prize winner economist James Tobin believes that in the long term discount rates should not be used, since their use '(...) reflects the impatience of those on the globe who would like their goodies now'.15

10 The question for economists is not only to estimate the cost of future damages, but also how much the gains from, for example, saved species are worth. The benefits could be vaccines, or just the enjoyment of the existence of the species (Goulder and Stavins 2002, 674). As David Pearce said, 'A first step should be to improve the measurement of the value people put on the environment (...). Put a proper value on an environmental "good", and the balance between costs and benefits will start to look greener' (Heathfield and Russell 1992, 412, quoting an unpublished lecture by Pearce).

11 To 'justify an aggressive and expensive effort to slow global warming', Cline suggests a discount rate of 2 per cent (see Stokes 1992, 124—25).

12 IPCC 2001b.

13 Innovest 2002a, 7.

14 See Weiss 1990, for a proposal of how to protect the interests of future generations.

15 Stokes 1992, 124-25.

The use of discount rates is based on Irving Fisher's time-preference theory of interest shows the preference for today's relative to tomorrow's consumption (Figure 3.1). According to Fisher, the interest rate is determined by impatience and technological progress. The indifference curves U1, U2 and U3 represent the level of impatience about tomorrow's consumption of society or an individual. The production possibility frontier (PPF) demonstrates the possibility to transfer today's consumption into consumption of tomorrow. E is the equilibrium, in which satisfaction is maximized. The slopes of PPF and U2 in E are equal to minus (1 + r), with 'r' representing the real interest rate. The slopes express how much of the future goods are equivalent to today's goods. The assumption is that economic subjects are not willing to sacrifice today's consumption without getting any benefit for it. They favour today's consumption over tomorrow's consumption and want to be paid for waiting.

Figure 3.1 Fisher's Time-preference Theory of Interest

Source: Adapted from Samuelson and Nordhaus 1989, 387.

How much the choice of discount rate matters for the design of policy was illustrated by a study undertaken by William Nordhaus. Using the example of a tax on GHGs, he sought to determine an efficient policy response to climate change. In his 'maximum damage' scenario, a discount rate of 4 per cent suggests that an efficient level of the tax is USD 2.44 per ton of carbon, and the result would be a less than 5 per cent decrease in

Tomorrow's consumption t

Figure 3.1 Fisher's Time-preference Theory of Interest

Tomorrow's consumption

Source: Adapted from Samuelson and Nordhaus 1989, 387.

Today's consumption

Today's consumption emissions compared to business as usual. A discount rate of zero, however, suggests an efficient tax of USD 65.94 per ton of carbon, which would lower emissions by one-third.16

Renewable Energy Eco Friendly

Renewable Energy Eco Friendly

Renewable energy is energy that is generated from sunlight, rain, tides, geothermal heat and wind. These sources are naturally and constantly replenished, which is why they are deemed as renewable.

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