Sustainability and the Discount Rate: An Economist’s Perspective

By Randall Pozdena, PhD1

The first use of the term sustainability in the context of husbandry of the earth’s resources was at a United Nations meeting in Sweden in 1972. The term was not defined formally, however, until the UN’s Brundtland Commission issued a report in 1987. The Commission report defined sustainable development as “development that meets the needs of the present without compromising the ability of future generations to meet their own needs…”2

The notions of efficient allocation of resources and intergenerational equity were not new to economists. The UN had rediscovered concepts that economic philosophers Adam Smith and John Stuart Mill had elucidated in the 18th and 19th centuries respectively.3 The addition of the use of the vague notion of “needs” in the sustainability definition was not an improvement, from an economist’s point of view.4 However, the popularization of the sustainability terminology invigorated an important, long-standing debate – how to properly balance the allocation of resources among present versus future generations so as to maximize society’s welfare over a long time horizon.

Present Value and Discount Rates

The tool used by economists to incorporate future effects in today’s decisions is a mathematical calculation called present valuation. As the name implies, present value calculations allow complex streams of future benefits or costs to be expressed as a single number in present day terms. A key parameter of this calculation is the rate of discount. This interest rate-like concept, in effect, determines by how much a future receipt of a dollar need be discounted to make market participants indifferent between receiving the payment in the future or today.

There is a reason that the use of the appropriate discount rate is so important to the sustainability movement. It is because use of higher discount rates biases investment and spending choices toward those that yield net benefits in the near term versus the longer term. Conversely, use of a low discount rate favors activities that may yield small benefits in the near term relative to the long term.

A simple example illustrates the sensitivity of present value calculations to different discount rates.

Let us say that one must wait 50 years for a forest planted today to mature and yield $1,000,000 in revenue. How much should the landowner invest today planting the trees? If the landowner uses a discount rate per annum of 10 percent, the landowner can only justify spending about $8,500 planting the stand. If a discount rate of 3 percent were used instead, spending approximately $228,000 would be justified––an amount higher by almost 27 times.5

This example explains why the discount rate issue is so controversial in long-term, charged sustainability topics such as global warming. In 2006, the famous Stern Review on the Economics of Climate Change was published to guide UK climate policy. Stern had used a 1.4 percent discount rate. This resulted in a policy recommendation that 1 percent of GDP per annum be foregone for the sake of future generations’ economic well-being. Stern’s choice of such a low discount rate had amplified the present value of climate change costs by a factor of 4 relative to previous studies.

Eminent economists lined up as both critics and supporters of Stern’s discount rate selection, while environmental organizations and policy think tanks tended to align themselves along more predictable political lines.

The Social Discount Rate Debate

A layperson must wonder why the economics profession has not advanced a definitive opinion regarding discount rate policy in sustainability settings. In this section, we present a brief summary of the in-house debate among economists.

During most of the 100+ year history of financial mathematics, a view called the “revealed preference” view has prevailed regarding choice of discount rates. The concept behind this view is that the marketplace makes present value calculations all the time, and the various interest costs of borrowed funds observed in the market reflect the rate of discount implicit in the minds of borrowers and lenders. It is hard to dispute that bond and loan rates accepted voluntarily by borrowing and lending parties reflect these private sentiments, adjusted as needed by the size, risk, and duration of borrowing arrangements.

Nobel laureate Kenneth Arrow lent some weight to the conventional view in his comprehensive treatise with Kurz in 1970.6 However, over the years other economists advanced the notion that a special, lower “social discount rate” be used for government projects and policies that had multi-generational impacts. Ramsey, in 1928, for example, argued in favor of not discounting the future at all in public projects, saying that for government to do so was “ethically indefensible.” The logic of this view comes primarily from the assertion that, because future generations do not (by definition) participate in today’s financial market negotiations, their interests are underrepresented in balancing future benefits against present costs. If true, then government might wish to use a lower discount rate to advance intergenerational equity in access to resources.

Many economists view the social discount rate proposition as paternalistic and, more importantly, factually and conceptually flawed. The factual flaw is that this proposition is inconsistent with widely observed bequest activity, and other voluntary sacrifices of current consumption to preserve assets and resources for future generations.7 Indeed, in 2010 alone, over $191 billion8 in estate bequests were filed with the IRS.  Bequeathing such estates, instead of consuming them over one’s lifetime, will tend to put downward pressure on observed interest rates, with the same effect on discount rate. In effect, this addresses the intergenerational equity issue not only for those involved in the bequest, but for the economy as a whole.

The logical flaw in the case for a lower, social discount rate is that, contrary to the presumption, a current generation, in fact, has a natural, selfish economic interest in future generations of their and others’ offspring. This arises not only out of possible need for children’s assistance in old age, but also the consumption benefits of having prosperous offspring and opportunities for grandchildren to prosper and live in a prosperous society. Indeed, some economists have argued that the interest in future generations is, in effect, perpetual because grandchildren will be happy only if their children have the prospect of being happy, etc. Studies of family income dynamics over multiple generations confirm that patience in consumption by the current generation is, indeed, passed along to the next generation.9

Practical Considerations

The theoretical debate about whether or not to use low, social discount rates has become increasingly arcane and, in this author’s view, unhelpful.10 Moreover, in practice, other phenomena and practices are ignored that bear upon the state of the world that we pass to the next generation.

First, some of the theoretical demonstrations of the need for a social discount rate assume no technological progress. But we do enjoy technological progress and it constitutes an unavoidably trans-generational bequest.  Impoverishing the current generation may be counterproductive if it also retards the investment and private entrepreneurship needed to innovate.

Second, to the extent that adoption of very low discount rates results in material diminution of current incomes, the tables may be tilted toward more, rather than less, current consumption versus savings.  Economist Stephen Zeldes has demonstrated that “patience” in consumption is positively correlated with income.11

Finally, the popular view of our climate and environmental problems is that these problems represent a “market failure.” Market failures are viewed as soluble only by countervailing public activity. In fact, the problem may be more the case of government having failed to create the legal conditions to support a market in the first place than the failure of a functioning market.

The assignment of private rights has proven to be successful in the preservation of certain ocean fisheries via “catch share” privatization. Establishing such private property rights halts and restores beleaguered fisheries.12  It does so by avoiding the so-called “tragedy of the commons”, where lack of distinct property rights leads to joint plundering of a common resource.  Such approaches avoid the issue of evaluating the benefits and costs of direct, public interventions and, hence, the issue of the appropriate discount rate.

Summary

The notion of sustainability and its aim of balancing the needs and resources across generations is not a new or special concept from an economics standpoint. Though defined more vaguely, the sustainability notion is analogous to the economist’s traditional dynamic goal of allocating resources multi-generationally to the maximum benefit of society.

The choice of discount rates in the public sector context has long been a complex decision. It is an especially charged issue in the context of climate change policy, but also in many eco-system sustainability contexts. This brief article cannot address all of the features of this debate.13 However, it is probably fair to say that the economics profession remains divided on the issue of the use of very low, social discount rates in a sustainability setting, but is leaning against doing so.

In this economist’s view, the case for the use of low, social discount rates is too weak to justify its use, particularly where material disruptions of the economy will follow. In such cases, it seems prudent to first employ methods of engaging economic self-interest to address the risk of resource plundering, since we know so little about the consequences on technological progress of massive reallocations of resources through state interventions.

A good case can be made that market rates used to settle private financial matters already incorporate intergenerational welfare considerations through the inherent, multi-generational perspective of the human family. In my view, this justifies extending the revealed-preference approach to discounting to matters in the public realm as well.

 Notes

1Randall Pozdena, PhD CFA is Managing Director of ECONorthwest and President of QuantEcon, Incorporated.  He is a former professor of economics and finance, and former financial research vice president of the Federal Reserve Bank of San Francisco.  The author can be reached at pozdena@quantecon.comOpinions expressed herein are the author’s own.
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2 Our Common Future, Report of the World Commission on Environment and Development, World Commission on Environment and Development, 1987. Published as Annex to General Assembly document A/42/427, at Section IV-1.
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3 Smith, A. (1776). An Inquiry into the Nature and Causes of the Wealth of Nations, at Vol. 1., and Mill J. S. (1861). Utilitarianism at pp.251-32.
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4 Modern economists bridle at the term “needs”, preferring less vague and more readily measureable indicia of social welfare.
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5 The same large differences apply when a stream of annual values is relevant rather than a distant, one-time effect.  The present value of a stream of constant payments stretching 100 years into the future, for example, is over 4 times larger the present value using a 2 percent discount rate than a 10 percent discount rate.
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6 Arrow, K., and M. Kurz (1970). Public Investment, the Rate of Return, and Optimal Fiscal Policy, Baltimore: Johns Hopkins University Press.
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7 Source:  US Internal Revenue Services, Statistics on Income, retrieved October 2011.
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8 These statistics exclude estates that have avoided tax filing requirements or been distributed to the next generation through gifting, insurance, or other bequest strategies before death.
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9 See, for example, Zeldes, S. (1989). Consumption and Liquidity Constraints: An Empirical Investigation, Journal of Political Economy, 97(2), at 305-346, and Becker, G. and. C. Mulligan. (1994).  Endogenous Determination of Time Preference. Gary S. University of Chicago. Revised, July 20 1994.
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10 An example is an article by Caplin and Leahy (2004) who argue that the current theory ignores prior generations’ welfare, and if certain specific conditions hold, doing so resurrects the lower, social discount rate policy.  See, Caplin A. and J. Leahy, 2004. “The Social Discount Rate,” Journal of Political Economy, University of Chicago Press, vol. 112(6), at pages 1257-1268.
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11 See Zeldes, op cit.
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12 Costello, C., S. Gaines and J. Lynham (2008). “Can Catch Shares Prevent Fisheries Collapse?” Science 19 September 2008: 321 (5896), at pp. 1678-1681.
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13 For a more technical and comprehensive discussion of discount rates, see Arrow, K.J., et al. (1995).  Intertemporal Equity, Discounting, and Economic Efficiency, in Climate Change 1995: Economic and Social Dimensions of Climate Change, Contribution of Working Group III to the Second Assessment Report of the Intergovernmental Panel on Climate Change, (J.P. Bruce & Haites E.F. eds., 1996).
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