Climate change and the importance of the discount rate

The ongoing talks regarding climate change (and what to do about it) seem to take as given that “something” should be done to try to prevent climate change. Abstracting from arguments regarding any scientific consensus about whether or not humanity’s actions are at least contributing to climate change, these talks still do not question whether it is economically rational to do something about climate change.

Indeed, the fact that the impact of any climate change is likely to be (relatively) far into the future, whereas the costs that would be incurred to try to stop climate change would be incurred much sooner does make it difficult to evaluate the extent to which there is an economic case for doing something to stop climate change.

This is where something like the Stern Review should come in – it was an attempt to examine the economic impact of climate change and, hence, whether or not it made economic sense to try to counter the effects of climate change. Stern concluded that there was a strong economic case for acting to prevent/mitigate climate change. However, its approach was fundamentally flawed.

In particular, the Stern Review’s treatment of the “discount rate” (i.e. the amount used in the conversion of future sums to present values) meant that it overstated the current value of the future benefits of preventing climate change. Although the Stern Review accepts that there is some need for discounting due to the fact that £1 in the future can buy less than £1 today (i.e. inflation erodes the value of the same nominal sum), the Stern Review unjustifiably rejects the notion that people have an inherent preference for receiving beneficial things sooner rather than later.

The rejection of the second reason for discounting future sums means that the discount rate used by Stern is an artificially low 1.4%. This is in stark contrast to the 4% – 6% discount rate for developed countries that is suggested by Markandya et al (2001) and even below the 2% -3% suggested by Halsnae et al (2007) – both of these figures were estimated by the IPCC itself.

Although these differences of a few percentage points a year might not seem like much, over time they add up. To see this, the graph below shows the present value of receiving £100 x years into the future under different discount rates. The x axis indicates how many years into the future the sum is received, while the y axis shows how much that sum would be worth in present value. The black line indicates how the present value of the £100 declines over time under a discount rate of 1%, while the blue and red lines show the progression under discount rates of, respectively, 3% and 5%.

Discount rates

The difference between the three lines is stark – despite only a two percentage point difference between a 1% discount rate and a 3% discount rate, the gap between the present value under the different discount rate is substantial after just 10 or so years.

How, then, does using a more appropriate discount rate alter Stern’s conclusions. Well, Stern puts the central estimate of the global cost of not acting to prevent climate change at about 5% of global GDP – i.e. roughly $5 trillion. Let’s (conservatively) assume that the full extent of these costs would be incurred starting from 2100 – i.e. that in 85 years the costs of not doing anything to combat climate change would be $5 trillion. Using Stern’s own discount rate of 1.4%, that puts the net present value of mitigating climate change at about $1.5 trillion per year. Given that Stern estimates that the costs of mitigating climate change are about $1 trillion per year in about 2050 (and let’s not get into whether or not Stern has underestimated these costs as that has been covered thoroughly elsewhere, nor the fact that these costs would need to be incurred on an annual basis for at least 30-odd years before the benefits from mitigating climate change would be felt) – i.e. about $615 billion per year in the present day using Stern’s discount rate – Stern concludes that acting to mitigate climate change is economically rational.

However, using the more appropriate discount rate of 4% per year, the benefits from ameliorating climate change have a present value of the benefits from mitigating climate change of  about $178 billion per year, while the present value costs of mitigating climate change (using that same discount rate) are roughly $253 billion per year.

In other words, using a more appropriate discount rate means that Stern’s conclusions are completely reversed – instead of there being a net economic benefit from acting to mitigating climate change, doing so actually results in an economic loss.

It is rather damning that Stern chose to bury this part of his assessment in a technical annex to an addendum to his original review. And yet this report is relied on as evidence that there is an economic case for climate change despite the fact that the evidence does not support that conclusion.

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