Discount Rates and Approaches towards Valuing Climate Projects

Valuing the future can be tricky and when determining how to do so in the face of climate change, it becomes more important than ever to make sure discounting is done correctly. With that being said, valuing the long-term benefits of climate change projects has been a hot topic and thinking about tradeoffs between today and the future always brings up challenges. Using academic literature and what I learned from one of my professors, Johannes Stroebel, I want to dive into the question of how policymakers should think about discount rates.   

Discount Rates

Solving the question of discount rates is the most critical part of unlocking global climate policy and helping achieve any Net Zero by 2050 goals; therefore, it warrants a lot of attention. For the Office of Management and Budget, the Circular A-4 is an important document that helps federal agencies understand cost-benefit analysis when conducting any regulatory actions, one being project deveopment. Since 2003, the discount rate recommendation used to be 3 to 7 percent, but has recently changed to 2 percent last November. While this may not have made headlines in the WSJ or NYTimes, it is a highly important reconsideration as now federal agencies will now be able to justify more easily climate projects by showing the higher valuation that comes with projects as compared to before. While there has been some concern for how the rate was justified, it should be noted that this is now more in line with Professor Stroebel’s long-run discount rate of 2.6% for how individuals look at future benefits for very long-run outcomes of 100 years or more, which relates to climate projects. For why this lower discount rate makes more sense than the upper-bound 7 percent the OMB tried to use in the past, it is important to understand climate projects as a hedge against decreasing economic activity rather than a risky investment.     

One way of thinking about climate projects and discount rates starts with seeing climate change as a byproduct of economic output. In states of the world where the world is rich and there is high GDP growth, there is a lot of climate change. While this may not be the case for all countries as the website Our World in Data may indicate, let us still use this argument to explain the point. Climate change is seen as a tax on consumption and once consumption, hence growth, starts to eventually decrease, climate change disasters will also decrease. This makes sense when you believe that there is a strong beta between these two variables. What this means is that climate projects will only pay off if there are bad climate disasters and will not pay off in good states of the world. This can be seen as risky investment if someone thinks about it like this, which is why valuing a climate project would necessitate a high discount rate. It is when you reach that tipping point of decelerated growth when the climate project is reduced in value. 

However, there is a second approach towards thinking about discount rates with respect to climate change. In this approach, we should understand that while climate damages will increase with states of the world with high economic output, so will the probability of them occurring. If the frequency of these disasters keep on occurring, then this creates large economic risks to the country. There is this feedback loop that some people tend to miss where it is not just that economic growth affects climate change but also that climate change affects economic growth. Therefore, if climate change is the cause for decreasing economic output, that would mean that it creates bad states of the world, not good ones. When thinking about utility functions, investments always pay off more in bad states of the world than good ones. If I could earn 50 dollars in a bull economy or bear economy, making 50 dollars in a bear economy would grant me more satisfaction. Therefore, low discount rates should be used since these projects should be seen as a hedge. Climate change is ultimately creating bad states of the world and because we value things more so in those scenarios than good scenarios, applying a low discount rate makes sense. The argument of applying a high or low discount rate has been argued by policymakers and academics for years, but I believe that the second approach gives a more clear picture of why a low discount rate should be used. 

Creating Welfare Across Generations 

Therefore, If climate projects are seen as a hedge, it makes sense to start investing in them as they prove to be much more valuable than if they are thought of as a risky investment. What now needs to be solved is what method to actually discount and to make sure intergenerational equity is achieved. One way to value the future benefits of climate projects is to just apply a fixed discount rate. The biggest problem is that any future damages that may occur due to climate change have no effect on present-value terms, if applying one fixed rate. As mentioned, taking on the view that climate change exacerbates the frequency and severity of climate disasters is important to note, creating bad states of the world. However, if we just apply a single discount rate for a project over 50 years, then the discount rate being used in the present-day places no weight on future climate damages, meaning that it is undervaluing climate projects. 

There is another method where you do not even use a discount rate when finding the cost-benefit of a project because the whole idea is that we need to take on the ethical approach that every generation’s welfare deserves to be treated equally. This runs into a lot of problems. One, there is always the case that climate change wipes out all humans, so there has to be some added risk incorporated into valuing future benefits of projects. Also, when thinking about how humans make decisions, it would be foolish to think that someone cares the same amount about something happening in 50 years as something happening in 5 minutes. I do not see this as a reasonable method.

In my opinion, the use of declining discount rates should be the method of choice. By using declining discount rates, the method places large weight on the value these projects hold for the future and helps governments justify the long-term benefits for the climate. If climate change affects economic growth negatively and exponentially, this would imply that these projects become more valuable in the long-term than the short-term. This does rely on some assumptions though. The first is that this thinking only works if the world is not at a tipping point where climate change starts to reverse. The second is that change is not a tax on peoples’ consumption and people keep on consuming regardless of if the world keeps on getting worse. 

I hope you liked this article. If my thinking is flawed, please let me know as I am still trying to learn how to think about this as these were my immediate thoughts.     

Sources

Climate Change and Long-Run Discount Rates, pages.stern.nyu.edu/~jstroebe/PDF/GMRSW_Climate.pdf. Accessed 10 Feb. 2024.

Hepburn, Cameron. Valuing the Far-off Future: Discounting and Its Alternatives, www.lse.ac.uk/GranthamInstitute/wp-content/uploads/2014/02/discount-rates-climate-change-policy.pdf. Accessed 10 Feb. 2024.

Morgan, Elena. “Climate Change, Discounting, and the Tragedy of Horizons - News & Insight.” Cambridge Judge Business School, 11 July 2022, www.jbs.cam.ac.uk/2021/climate-change-discounting-tragedy-of-horizons/.

Ritchie, Hannah, and Max Roser. “Many Countries Have Decoupled Economic Growth from CO2 Emissions, Even If We Take Offshored Production into Account.” Our World in Data, 28 Dec. 2023, ourworldindata.org/co2-gdp-decoupling.

Stuart Shapiro, opinion contributor. “OMB Just Did Something Boring but Important.” The Hill, The Hill, 28 Nov. 2023, thehill.com/opinion/finance/4329892-omb-just-did-something-boring-but-important/.