The Social Discount Rate

by Emma Heiling

How much is it worth to us today to avoid climate disasters later this century? Economists, government analysts and policymakers often use a cost-benefit analysis to answer such questions, and within that the Social Discount Rate (SDR) plays a crucial role [1]. The SDR represents the value we place on the welfare of future generations and consequently the cost that society today should bear for future generations [1]. A low SDR means we place a similar value on future generations as we do on current ones, a high SDR means the opposite [2]. In a climate context, a high SDR gives less importance to future generations’ wellbeing in cost-benefit analyses, and therefore supports less ambitious climate action policies (high cost/small benefit) [2]. 

Reasons for discounting 

There are two reasons, usually proposed by economists, for discounting the future [2]. The first reason is often referred to as inherent discounting, pure time preference or impatience and simply states that people generally prefer income today rather than tomorrow (for example we would prefer receiving €100 today than in 10 years) [2,4]. The second reason is that it is expected that economic growth will lead to wealthier societies and those higher incomes will mean that a dollar today is worth more than a dollar in the future [2].

How does the Social Discount Rate affect climate policy? 

Climate change effects are global and have a time-lag problem – they affect multiple generations as well as societies [4]. Taking the example from Roberts (2021), if climate change were predicted to cause $5 trillion in damages by the end of the 21st century, at an SDR of 3% it would only be worth $382 billion to us today to avoid – the higher the discount rate you apply, the lower the amount it is worth to us today; or the higher the SDR, the lower the carbon price [4]. Therefore, by using high discount rates like in the above example, we will barely spend anything on climate policy today. 

Stern vs Nordhaus 

Different social discount rates have been used in climate models. Here we will look at Stern’s approach in contrast to Nordhaus’ approach. 

Nicholas Stern wrote the 2006 Stern Review for the UK Government [9]. This review looks at the effect of global warming on the world economy. Stern finds that the costs of early action would be much lower than the costs of inaction [5]. One of the reasons for the high costs of inaction is the low social discount rate used. Stern chose a near-zero time preference rate of 0.1% whereby he argued that the only reason to discount future generations is the possibility of a catastrophic event, like a comet hitting Earth, which would wipe out all life [6,10].

William Nordhaus, who is known for his work in economic modelling and climate change and received the 2018 Nobel Prize in Economics, has criticised the Stern Review for its low discount rate. Nordhaus looks at a model similar to the one in the Stern Review, but using a much higher time preference rate of 3% (which slowly declines to 1% in 300 years) [6].* He gives much less weight to the welfare of future generations and concludes, in contrast to Stern, that only few preventive climate measures are required [6]. Nordhaus’ optimal carbon price was $7.40/ton (meant to rise 2-3% every year), whereas Stern’s suggested carbon price was around $85/ton and rising [4]. 

One of the reasons Nordhaus used for his high discount rate was the second one I mentioned above. He assumed future generations to be wealthier and thereby found that society today should not incur such high costs for societies that will be much wealthier anyway [6]. He also found that a 4°C global temperature increase over pre-industrial levels would only reduce global GDP/capita by 2-4% [8]. This stands in contrast to Stern, who found that inaction could lead to a loss of global GDP of up to 20% ‘each year, now and forever’ (which, of course, would affect future generations’ wealth) [5].

Nordhaus has often been criticised for his approach by climate scientists, experts and activists and many believe that the lack of radical government action in the last decades is ‘in large part due to arguments that Nordhaus has advanced’ [7]. 

Conclusion

In conclusion, for strong climate action, we need policymakers to use an SDR of, ideally, zero. It is now already widely accepted that SDRs should decline over time [2]. Some key arguments for using low, or at least declining SDRs, are the uncertainty of future growth (e.g. impacted by climate disasters), the fact that market rules may not be in line with social welfare, or the global nature of the climate crisis (‘future generations’ are assumed to be generations of us, not vulnerable countries; e.g. losing the entire African continent due to climate catastrophes would be entirely compatible with global economic growth, as Africa does not contribute significantly to global GDP) [2,4]. 

*Note that I am using the term time preference rate instead of social discount rate, since these are more easily comparable and are used in the majority of articles. The full social discount rates (which are calculated using the time preference rates and the average growth rate of consumption per capita) are 1.4% in the Stern Review and 4.3% in the Nordhaus model [10,11]. 

References: 

[1] James Broughel, 2017, The Social Discount Rate: A Baseline Approach, Mercatus Center – George Mason University,  URL:https://www.mercatus.org/publications/regulation/social-discount-rate-0, accessed on 11/06/2021.  

[2] LSE Grantham Research Institute on Climate Change and the Environment, 2018, What are social discount rates?, URL: http://www.lse.ac.uk/granthaminstitute/explainers/what-are-social-discount-rates/, accessed on 11/06/2021.

[3] John Quiggin, 2006, Stern and the critics on discounting, School of Economics and School of Political Studies and International Relations, University of Queensland, URL: https://web.archive.org/web/20110127222724/http://johnquiggin.com/wp-content/uploads/2006/12/sternreviewed06121.pdf, accessed on 11/06/2021.  

[4] David Roberts, 2012, Discount rates: A boring thing you should know about (with otters!), Grist, URL: https://grist.org/article/discount-rates-a-boring-thing-you-should-know-about-with-otters/, accessed on 11/06/2021. 

[5] Nicholas Stern, 2006, Stern Review: The Economics of Climate Change, URL: https://webarchive.nationalarchives.gov.uk/20100407172811/http://www.hm-treasury.gov.uk/stern_review_report.htm, accessed on 11/06/2021. 

[6] Hal R. Varian, 2006, Recalculating the Costs of Global Climate Change, The New York Times, URL: https://www.nytimes.com/2006/12/14/business/14scene.html, accessed on 11/06/2021. 

[7] Jason Hickel, 2008, The Nobel Prize for Climate Catastrophe, Foreign Policy, URL: https://foreignpolicy.com/2018/12/06/the-nobel-prize-for-climate-catastrophe/, accessed on 11/06/2021. 

[8] Steve Keen, 2018, Climate Change: Extinction or Adaptation?, Patreon,  URL: https://www.patreon.com/posts/climate-change-30728029, accessed on 11/06/2021.

[9] LSE Grantham Research Institute on Climate Change and the Environment, 2006, The Economics of Climate Change: The Stern Review, URL: https://www.lse.ac.uk/GranthamInstitute/publication/the-economics-of-climate-change-the-stern-review/, accessed 11/06/2021.

[10] Simon Dietz, 2008, A long-run target for climate policy: the Stern Review and its critics, LSE Grantham Research Institute on Climate Change and the Environment and Department of Geography and Environment, PDF: https://personal.lse.ac.uk/dietzs/A%20long-run%20target%20for%20climate%20policy%20-%20the%20Stern%20Review%20and%20its%20critics.pdf, accessed on 11/06/2021.   

[11] Lawrence H. Goulder & Roberton C Williams III, 2012, The Choice of Discount Rate for Climate Change Policy Evaluation, Resources for the Future, PDF: https://media.rff.org/documents/RFF-DP-12-43.pdf, accessed on 11/06/2021.  

Categories Economic Concepts

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