Future in an Equation

In the past three articles on the Economics of Climate Change, we have discussed the concept of the social discount factor. In particular, in the comparison of Stern and Nordhaus, we saw that their models offer contrasting strategies for addressing climate change: while Nordhaus suggests a gradual ramping of action as more knowledge becomes available, Stern wants emergent action starting today, before it is too late. The contrasting strategies depend on the discount factor used by Stern and Nordhaus: while Stern uses a low discount factor, which means that the future is as important as the present, Nordhaus uses a higher discount factor, which means that present challenges are more important. Given the importance of the social discount factor, let us discuss this in more detail.

The Social Discount Factor (SDF): A Discussion

The SDF is not a new concept and has been around for a while in welfare economics. It has been widely used for evaluating the costs and benefits of large infrastructure projects and other policies involving capital expenditure, which have long implementation times and last long after completion. As is well known, cost-benefit analysis (CBA) has been widely used to decide one policy or project over another based on the costs and benefits over a long period, converting these into a current monetary value (also called the net present value). The underlying assumption is that future costs and benefits ‘diminish’: how much they diminish depends on the SDF.

From the perspective of climate change, the SDF is therefore important because its value will determine what actions have to be taken and when. If a low SDF is assumed, as Stern did (1.4 per cent), it means that the future is almost as important as the present, and hence mitigation and adaptation measures have to be taken up on a large scale immediately. On the other hand, in the case of a high SDF, in Nordhaus’ opinion (4.3 per cent), climate action would be calibrated over time.

Stern relates the choice of the SDF to ethics and suggests that labelling his discount rate as ‘low’ in relation to market rates is to misinterpret the assumption. In his 2008 article, The Economics of Climate Change, published in the American Review, he writes:

It (the confusion) arises from inappropriate application of a marginal context to a strongly non-marginal context (climate change), failure to apply modern public economics, ignorance of the multi-good nature of this problem and, in some cases, ignorance of the difference between a social discount rate and a pure time discount rate.

In most models in welfare economics, the objective function we want to maximise is aggregate welfare, which is simply the sum of the utilities of all individuals over a period of time, which in turn is just the consumption of individuals over time. Stern contends that the SDF will be different for different consumption paths. While planning for climate change, governments have to pick among competing growth patterns across sectors. Further, the SDF will vary over time, and in the case of uncertainty, there will be a different SDF for each outcome. Finally, Stern contends that economists like Nordhaus and Weitzman use the market investment return as the SDF, which is mistaken, because this rate is not the same as the social rate of interest or the SDF.

Nordhaus’ response to this criticism of Stern is that today’s consumption discount rates, reflected in the savings rate, should be used, and that it was inappropriate to magnify the impacts of climate change 50–100 years from now. Further, it would be more ethical to focus more on today’s welfare and not incur high costs for the welfare of future generations, who would be wealthier anyway.

Conclusion

From the discussion above, it is clear that the numerical value of the SDF boils down to a simple question: how much value we place on future generations. From the extreme weather events that we have witnessed in the last decade and continue to witness, it is evident that these events have accelerated and will continue to do so in the future. The imperative for immediate action seems a more prudent strategy than delaying action on climate change. Stern’s low SDF, therefore, appears to be more appropriate, because inaction today will be far costlier. Further, Nordhaus’ argument that future generations will be wealthier and can take care of their welfare may not prove to be true if climate change leads to widespread damage to infrastructure and economic and natural resources, poor social outcomes (bad air, frequent flooding, and extreme heat causing poor health and displacement of large populations), and lower growth rates. Stern’s prescription also seems better if fat-tail events, such as very high levels of greenhouse gas emissions leading to catastrophic outcomes, are taken into account. It is better to act in haste now rather than repent at leisure later.