Long run investment in climate change and the tyranny of discount rates

05 May 2021

Cost benefit analysis for investment in mitigating of and adaption to climate change and its effects is a difficult and controversial topic. From an economic viewpoint there are several issues: first how to aggregate across the range of outcomes, noting that many could occur sequentially with correlated triggers; second, the degree to which interventions in emissions will adjust these outcomes; third, the appropriate discount rate at which to compute the present value of future losses. The first and second issues are socio-technical, a modelling approach can take a reasonable precautionary approach by assuming that reduction in emissions will reduce the future losses; similarly a precautionary approach to the likelihood of extreme negative events and path dependency can be modelled. However, the third issue, on the choice of discount rate, is an important sticking point and was one of the major critiques, particularly from US commentators, on the 2006 Stern Review on the Economics of Climate Change, by Baron Stern of Brentford. For much of the modelling work on investment, this is arguably the key factor. Many of the extreme losses are sufficiently far enough into the future that even a modest discount rate radically reduces the present value of those losses, even with a precautionary probabilistic assessment. This valuation is critically important to the public discourse on how much should be spent, the value of mitigation and when investment should be ramped up. We will discuss Baron Stern of Brentford’s argument that the discount rate should be set very close to, or at, zero and then discuss the impact of this assumption on the wider political discourse, particularly in the United States.

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