Declining Discount Rates: Economic Justifications and Implications for Long-Run Policy

This thesis studies the issue of time declining discounting in climate change projects evaluation in two different contexts: deterministic and uncertain world. First, an overview of standard discounting is introduced in the second chapter to help explaining why this approach is not appropriate in long term project evaluation. It then comes to the central focus on the concept of time declining discounting, which is sequentially presented in chapter 3 and chapter 4 by investigating current literature relating to the identified topic. In chapter 3, we rationalize the use of time declining discounting in a deterministic world in the light of two main theories developed by Sterner (1994), and Weitzman (1994). Although the two approaches are different from each other, they both consider the environmental aspects as factors making the consumption discount rates declining over time. In chapter 4, we investigate time declining discounting in case of an uncertain world with the focus on uncertain discount rates and uncertain economic growth. Assuming the discount rate is uncertain, we adopt the theory studied by Weitzman (1998), and Newell and Pizer (2003) to explain why discount rates could be declining over time. When the future economic growth is unknown from today"s perspective, we employ Gollier"s (2002) theory about precautionary effect to legitimate the decline of consumption discount rates over time. Chapter 5 presents the application of time declining discounting in climate change policy and its implications. Chapter 6 concludes.

… . Disponível em: http:// …, 2006

Monetary valuation of climate-change impacts, and the cost-benefit analysis of climate-change policy into which it feeds, has long been controversial. Writers in ecological economics have done much to illuminate its difficulties. For the purposes of this paper, the key difficulties of the cost-benefit approach are, first, discounting future costs and benefits at comparatively high rates, second, the often implicit assumption of perfect substitutability between natural capital and other forms of capital and, third, the treatment of uncertainty, much of which is very difficult to quantify in this case. On the other hand, alternative approaches to climate-change policy based on safe minimum standards are not without their weaknesses either. They are largely arbitrary and, as a result, arguably more politically unstable. Thus the in-principle need for cost-benefit analysis will not diminish.

Journal of Applied Econometrics, 2007

Evaluating investments with long-term consequences using discount rates that decline with the time horizon, (Declining Discount Rates or DDRs) means that future welfare changes are of greater consequence in present value terms. Recent work in this area has turned towards operationalising the theory and establishing a schedule of DDRs for use in cost benefit analysis. Using US data we make the following points concerning this transition: i) model selection has important implications for operationalising a theory of DDRs that depends upon uncertainty; ii) misspecification testing naturally leads to employing models that account for changes in the interest rate generating mechanism. Lastly, we provide an analysis of the policy implications of DDRs in the context of climate change for the US and show that the use of a state space model can increase valuations by 150% compared to conventional constant discounting.

Science of The Total Environment, 2011

Cost–benefit analysis is a standard methodological platform for public investment evaluation. In high environmental impact projects, with a long-term effect on future generations, the choice of discount rate and time horizon is of particular relevance, because it can lead to very different profitability assessments. This paper describes some recent approaches to environmental discounting and applies them, together with a number of classical procedures, to the economic evaluation of a plant for the desalination of irrigation return water from intensive farming, aimed at halting the degradation of an area of great ecological value, the Mar Menor, in South Eastern Spain. A Monte Carlo procedure is used in four CBA approaches and three time horizons to carry out a probabilistic sensitivity analysis designed to integrate the views of an international panel of experts in environmental discounting with the uncertainty affecting the market price of the project's main output, i.e., irrigation water for a water-deprived area.The results show which discounting scenarios most accurately estimate the socio-environmental profitability of the project while also considering the risk associated with these two key parameters. The analysis also provides some methodological findings regarding ways of assessing financial and environmental profitability in decisions concerning public investment in the environment.► Cost–benefit analysis (CBA) is a standard platform for public investment evaluation. ► We describe some recent approaches to environmental discounting. ► We integrate the views of an international panel of experts in environmental discounting. ► A Monte Carlo procedure is used in four CBA approaches and three time horizons. ► We present the economic evaluation of a plant for the desalination of drainages.

2007

In a recent paper, Newell and Pizer (2003) (N&P) build upon Weitzman (1998, 2001) and show how uncertainty about future interest rates leads to 'certainty equivalent' forward rates (CER) that decline with the time horizon. Such Declining Discount Rates (DDR's) have important implications for the economic appraisal of the long-term policy arena (e.g. climate change) and inter-generational equity. This paper discusses the implications of N&P's transition from the theory to practice in the determination of the schedule of discount rates for use in Cost Benefit Analysis (CBA). Using both UK & US data we make the following points concerning this transition: i) to the extent that different econometric models contain different assumptions concerning the distribution of stochastic elements, model selection in terms of specification and 'efficiency criteria' has important implications for operationalising a theory of DDR's that depends upon uncertainty; ii) mispecification testing naturally leads to employing models that account for changes in the interest rate generating mechanism. Lastly, we provide an analysis of the policy implications of DDR's in the context of climate change and nuclear build in the UK and the US.

Econometrics Informing Natural Resources Management

Opec Energy Review, 2009

The Stern Review on the economics of climate change has been a huge international event. It also raised an ardent controversy on the use of economic methodology. Did the Stern team cook the book to reach desired catastrophic outcomes? This paper is focused on the specific debate on time discounting when far distant future is at stake. Examining arguments of protagonists, it concludes that the Stern Review's foundations were consistent with the utilitarian philosophy without falling into empirically erring conclusions, while critics of the Review had to reveal the dubious set of assumptions on which their own views were based. But the standard translation of utilitarianism into cost-benefit analysis can be questioned. Various avenues of progress are identified.

Journal of Benefit-Cost Analysis

Uncertain futures" refers to a set of policy problems that possess some combination of the following characteristics: (i) they potentially cause irreversible changes; (ii) they are widespread, so that policy responses may make sense only on a global scale; (iii) network effects are difficult to understand and may amplify (or moderate) consequences; (iv) time horizons are long; and (v) the likelihood of catastrophic outcomes is unknown or even unknowable. These characteristics tend to make uncertain futures intractable to market solutions because property rights are not clearly defined and essential information is unavailable. These same factors also pose challenges for benefit-cost analysis (BCA) and other traditional decision analysis tools. The diverse policy decisions confronting decision-makers today demand "dynamic BCA," analytic frameworks that incorporate uncertainties and trade-offs across policy areas, recognizing that: perceptions of risks can be uninformed, misinformed, or inaccurate; risk characterization can suffer from ambiguity; and experts' tendency to focus on one risk at a time may blind policymakers to important trade-offs. Dynamic BCAwhich recognizes trade-offs, anticipates the need to learn from experience, and encourages learningis essential for lowering the likelihoods and mitigating the consequences of uncertain futures while encouraging economic growth, reducing fragility, and increasing resilience.

SSRN Electronic Journal, 2022

Integrated assessment models have become the primary tools for comparing climate policies that seek to reduce greenhouse gas emissions. Policy comparisons have often been performed by considering a planner who seeks to make optimal trade-offs between the costs of carbon abatement and the economic damages from climate change. The planning problem has been formalized as one of optimal control, the objective being to minimize the total costs of abatement and damages over a time horizon. Studying climate policy as a control problem presumes that a planner knows enough to make optimization feasible, but physical and economic uncertainties abound. Manski, Sanstad, and DeCanio (2021) proposed and studied use of the minimax-regret (MMR) decision criterion to account for deep uncertainty in climate modeling. Here the authors study choice of climate policy that minimizes maximum regret with deep uncertainty regarding both the correct climate model and the appropriate time discount rate to use in intergenerational assessment of policy consequences. The analysis specifies a range of discount rates to express both empirical and normative uncertainty about the appropriate rate. The findings regarding climate policy are novel and informative. The MMR analysis points to use of a relatively low discount rate of 0.02 for climate policy. The MMR decision rule keeps the maximum future temperature increase below 2°C above the 1900-10 level for most of the parameter values used to weight costs and damages.

Energy Policy, 1999

Controversy surrounds climate change policy analyses because of uncertainties in climatic e!ects, impacts, mitigation costs and their distributions. Here we address uncertainties in impacts, and provide a method for quantitative estimation of the policy implications of such uncertainties. To calculate an`optimala control rate or carbon tax a climate-economy model can be used on estimates of climate damages resulting from warming scenarios and several other key assumptions. The dynamic integrated climate-economy (DICE) model, in its original speci"cation, suggested that an e$cient policy for slowing global warming would incorporate only a relatively modest amount of abatement of greenhouse gas emissions, via the mechanism of a small (about $5 per ton initially) carbon tax. Here, the DICE model is reformulated to re#ect several alternate published estimates and opinions of the possible damages from climatic change. Our analyses show that incorporating most of these alternate damage estimates into DICE results in a signi"cantly more aggressive optimal policy than that suggested by the original model using a single damage function. In addition, statistical distributions of these damage estimates are constructed and used in a probabilistic analysis of optimal carbon tax rates, resulting in mostly much larger (but occasionally smaller) carbon taxes than those of DICE using point values of damage estimates. In view of the large uncertainties in estimates of climate damages, a probabilistic formulation that links many of the structural and data uncertainties and thus acknowledges the wide range of`optimala policies is essential to policy analysis, since point values or`best guessesa deny policy makers the opportunity to consider low probability, but policy-relevant, outliers. Our presentation is o!ered as a prototypical example of a method to represent such uncertainties explicitly in an integrated assessment.