To evaluate the optimal level of public investments, governments regularly conduct cost-benefit analyses in which they weigh the value of the benefits of an investment against the value of the investments’ costs. In many settings, a project’s costs and benefits materialize over different time horizons. This is particularly the case when considering investments to abate the effects of climate change. Indeed, many of the costs associated with climate change, such as large-scale coastal flooding and long droughts, are predicted to occur decades or even centuries into the future. However, societies have to invest today in order to effectively mitigate and reduce these long-run risks.
To compare the benefits and costs occurring at different horizons, future values are discounted to the present using a discount rate. When the time horizons are as long as they are for climate change, even small changes in discount rates can dramatically alter policy conclusions. As an example, assume that an investment to reduce carbon emissions costs $30 billion, and is expected to avoid environmental damages worth $1,000 billion in 100 years. At a discount rate of 3%, the present value of those damages is $52 billion and the project appears attractive. At an only slightly higher discount rate of 5%, the present value of the investment drops by an order of magnitude to $7.6 billion, and the project no longer is a good investment.
The selection of the appropriate discount rate is therefore of central importance when evaluating investments in climate change abatement. However, until recently, there has been very little direct empirical evidence on the way households discount payments over very long horizons. As a result, academics and policymakers have mostly resorted to theoretical arguments or have tried to infer discount rates from realized returns of traded assets such as private capital, equity, bonds, and real estate. This approach has produced widely varying discount rate suggestions, ranging from close to 1% (Stern 2006) all the way up to almost 5% (e.g. Gollier 2013, Nordhaus 2013). In addition, this approach often ignores important considerations regarding the maturity and risk properties of the investments used to infer discount rates for valuing climate change abatement.
To see why such risk and maturity characteristics are important, it is helpful to think of any asset as a portfolio of claims to single payments at specific horizons. For example, an investment that pays off some cash flows for the next ten years can be thought of as a portfolio of ten claims to single annual cash flows. Asset pricing theory teaches us that the rate at which each of these expected payments should be discounted depends on the situation in which the payment is realized. In particular, payments that materialize primarily when investors are doing relatively well (when their “marginal utility of consumption is higher”) are considered more risky and therefore less desirable than payments that pay off in bad states of the world (such payments are sometimes called “hedges” and are similar to insurance contracts). Payments that are more risky therefore need to be discounted at a higher rate; in other words, in order to compensate investors for the higher risk inherent in these payments, they have to offer a higher return.
In addition, since the riskiness of payments can vary by horizon, each of the single payments of the portfolio might have a different per-period discount rate. The average rate of return to an asset only captures the value-weighted average discount rate applied to all its payments. Therefore, it is not necessarily informative for discounting the payments of climate change investments, which tend to occur at much longer horizons and might have substantially different risk profiles.
Gollier, C (2013) “Evaluation of long-dated investments under uncertain growth trend, volatility and catastrophes”, Toulouse School of Economics TSE Working Papers 12-361.
Nordhaus, W D (2013) The climate casino: Risk, uncertainty, and economics for a warming world, Yale University Press.