Climate change and the discount rate: Part 2

As an (unplanned) follow-up to my previous post regarding the impact of the discount rate on analyses of the net benefits of mitigating climate change, let’s have a look into recent estimates of what the appropriate discount rate for assessing said mitigation benefits should be.

More specifically, the NBER recently linked to a paper written by Giglio, Maggiori, Stroebel, & Weber that purports to show that 1) the discount rate that should be used to assess the net benefits of mitigating climate change is at most 2.6%; and 2) therefore,  rates of return on some risky asset classes are not appropriate proxies for the discount rate.

It is the first claim that is demonstrably erroneous, and means that the discount rate that should be used is likely to be higher than 2.6% (and, hence, also implies that the paper’s second claim is not proven). As mentioned in my previous post, although using a discount rate as artificially as low as 2.6% would result in there being a positive net present value of mitigating climate change, using a (more appropriate) higher discount rate reverses that result.

(As an aside, the aforementioned NBER paper is riddled full of holes – for example, the authors claim that “there are no property taxes [that affect the return on property investments] to be considered in the UK”. This is patently false – the authors have ignored, or are simply unaware of various taxes that property developers and management companies have to pay. Either way, this simple error casts serious doubt on the accuracy and reliability of the rest of their results.)

The authors obtain the 2.6% estimate from a previous paper of theirs (rather shockingly, this flawed paper was published in the Quarterly Journal of Economics). In that paper, they looked at differences between the UK and Singapore prices of residential properties with time-limited leaseholds and those that are freehold. This difference reflects the value people place on holding a freehold relative to holding a leasehold with a certain number of years remaining and, hence, can be used to infer a discount rate for cash flows that occur in the very long run.

However, the results of that paper are driven by a fundamental misunderstanding of how long leaseholds and freeholds are treated by someone purchasing a house. The paper claims that leaseholds of more than, say, 500 years are different from freeholds because the leasehold can still expire and rely on this to validate their result. As such, the paper ignores the fact that, for all intents and purposes, a lease that long is treated in exactly the same way as a freehold (by buyers, sellers, estate agents etc.)

Moreover, the paper uses the result that rental values do not differ between freehold and leasehold properties (controlling for observable characteristics such as number of bedrooms etc) to claim that any systematic differences in unobserved characteristics between leaseholds and freeholds are unlikely to be prevalent. However, this ignores the fact that many properties (at least in the UK) are owner-occupied rather than rented. This means that the data they use misrepresent how people value residential properties and the factors that people take into account in their valuations. for example, it is plausible that someone purchasing a house to live in values it differently from someone purchasing the house as a buy-to-let – ignoring this means that the paper’s results are biased.

Furthermore, the paper relies on data covering only the period 2004-2013. In other words, a large part of the data used in the paper are affected by the impact of the global financial crisis, which is widely recognised to have depressed house prices. In addition, the paper fails to control for other relevant factors, such as changes in the housing stock in a particular area over time – as increases in the stock of housing in a particular area would affect the prices of existing houses, this is a grave omission.

Finally, the paper restricts their analysis to the prices of flats, and does not look at other forms of properties at all. This is a grave error since it biases their results towards being more leasehold-focused (flats are typically leasehold, whereas houses tend to be freehold). In other words, the paper fails to take into account a very large proportion of properties that are sold in the UK.

In other words, the result that the long-term discount rate is less than 2.6% is based on a flawed analysis. This means that the results of their latest paper (the one mentioned at the start of this post) are wrong. Indeed, the discount rate that should be used to obtain the net present value of the benefits from climate change is likely to be far in excess of 2.6%. Hence, the results shown in my previous post (that there is a net loss from mitigating climate change) still hold.

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