The devil is in the discount detail

When applied to macro decisions, the social discount rate (SDR) is used. Here, personal and business finance evolve into societal welfare and intergenerational equity. The SDR reflects the expected state of the world when benefits accrue, the netting of future income growth, and the opportunity cost of investments displaced by public funds. The standard SDR in the UK is set by HM Treasury’s Green Book at 3.5%. There is wide variance between SDRs globally, as shown in Figure 1, p34.

SDRs are often politically motivated. For example, Donald Trump’s US presidential administration claimed that a rollback in car fuel efficiency standards would generate $6.4bn in net economic benefits, justified by a discount rate of 7%, representing the average before-tax return on private capital. Under the previous Obama administration, the same standards were judged to provide a net economic benefit using a 3% rate, representing how much the average saver can earn. The 3% rate is more consistent with models used to generate the social cost of carbon. Although, given declining long-term interest rates, 3% may even have been too high.

Over the long run, seemingly small changes to SDRs can yield significantly different outcomes. Suppose damages from climate change are estimated to be £1trn in 2100. Using a discount rate of 3%, those damages are worth £100bn today, and just £6bn using a discount rate of 7%. We must at least question approaches to SDRs, as we also have a host of cognitive biases that serve to devalue future climate resilience. The most relevant are:

• Present bias, which prefers immediate rewards, even if they are of less overall value

• Optimism bias that a ‘silver bullet’ technological solution will be found, as with past problems

• Planning fallacy bias to underestimate the times, costs and risks of projects, which undermine pro-environmental investments with greater risk margins

• Status-quo bias that prefers to fully exploit what has already been invested in, rather than deal in new unknowns that may carry a higher chance of failure.

These ultimately flawed modes of thinking become entrenched in governing and decision-making structures, rewarded by society for delivering immediate benefits. This widespread irrationality cannot be overcome by the law of large numbers, as there is every reason to believe it is prevalent society-wide and does not self-correct with aggregate market forces.

"The social discount rate reflects the expected state of the world when benefits accrue"

Climate change can therefore be seen as a tragedy on the horizon, as it operates beyond relatively short-term social cycles (business, financial, political, etc). Costs and benefits must be measured on long timescales. Therefore, the discount rate can be critical in determining whether economic models support immediate action, as they determine the weights placed on points in time. A landmark report, entitled The Economics of Climate Change, The Stern Review, stated that high discount rates unethically undermine the welfare of future generations. As such, Stern argued for a low discount rate of 1.4%, comprised of the following:

• Pure rate of time preference: 0.1%, a normative stance to ensure that future generations are given almost the same weight as the current generation

• Consumption growth rate: 1.3%, a positive stance on the expectation of increasing wealth, making future generations better off than current ones.

There is a general growing consensus that lower discount rates should be used, as found by a 2021 survey of 738 economists by the Institute for Policy Integrity, New York University School of Law. We can also ask, however, if discount rates are appropriate at all. It is almost a certainty that unaddressed climate change will be catastrophic for human society. It therefore may be counterproductive to apply concepts of uncertainty to an issue that would certainly eliminate future income growth. Discounting implies fungibility between current and future costs and benefits.

In the case of natural capital (the world’s stock of natural assets), there is great uncertainty over whether natural and produced capital are substitutable, given the complex nature of ecosystems and increased scarcity of natural resources. This flawed thinking rationalises theories such as the Environmental Kuznets Curve, which state that countries can automatically grow and innovate their way out of environmental degradation, even though material consumption and emissions have continued to rise in both developed and developing countries.

Considering that the natural environment forms the complete basis of our existence on planet Earth, future values of sustainability could theoretically have an infinite value, owing to survival needs.

We cannot, however, expect people to entirely disregard the present, given ethical considerations. Historically, developed countries such as the UK have been some of the largest emitters of greenhouse gases since the industrial revolution, especially taking into account colonial rule. Many cumulative emissions therefore form a ‘carbon debt’ from developed countries to the rest of the world. Developing countries could justifiably use higher discount rates to address their more immediate needs, while developed countries look to the future. There could also be differential rates to account for the changing nature of costs and benefits.

The HM Treasury Green Book allows for lower discount rates to be used for projects extending past 30 years, lowering to 3% for those up to 75 years, and 2.5% for those up to 125 years. This accounts for the diminishing marginal utility of consumption over time. The Green Book also allows for lower rates to be used for specific policy areas, such as health, which is typically 1.5%. This reflects the high value placed on future health benefits compared with other types.

The Green Book does allow for some flexibility on environmental grounds – for example, when policies or projects involve long-term effects, which is usually the case for environmental issues. Or, where there are long-term and substantial or irreversible wealth transfers between generations, in situations such as irreversible changes to the natural environment. There is still no prescribed lower discount rate as with health or risk to life, however, which stunts progress in this area. It is also no secret that climate change itself comes with a host of health and risk-to-life factors.

Still, as climate change is a global issue that requires significant immediate action, the solution to addressing inequities remains far from clear. GDP growth and emissions are still closely correlated in many developing regions (primarily because of the use of coal to meet energy demand) and have instead become relatively decoupled in developed regions. Decoupling, however, may result from the offshoring of energy- and emissions-intensive manufacturing. For example, 44% of Scotland’s material footprint occurs abroad, accounting for 40% of all carbon emissions associated with material consumption.

"It is more economical to reduce emissions now rather than when social cycles deem it necessary"

At Zero Waste Scotland, our aim is to drive Scotland toward a circular economy. Strategies such as the Circular Economy Bill and the Circular Economy and Waste Roadmap to 2030, and individual policies such as extended producer responsibility, the single-use plastics directive, and the single-use vapes ban, all contribute towards climate resilience. These initiatives seek to tackle overconsumption and our throwaway culture, and to mitigate the embodied emissions in goods and services. High discount rates further encourage the linear economy, which prioritises immediate consumption over longer-term material sustainability. If the future impacts of the linear economy are not fully accounted for, associated environmental issues such as climate change and biodiversity loss will also suffer.

To conclude, there is strong evidence that current approaches to discounting unjustly devalue both the welfare of future generations and the need for building resilience. While discounting is often a useful tool in options appraisal, there are many underlying cognitive biases that run counter to generating overall societal welfare. It is more economical to reduce emissions now rather than when social cycles deem it necessary, because of the non-linear dynamics of cumulative emissions, and the presence of unknown tipping points and feedback loops, leading to unforeseen cascading effects on natural systems, from which there may be no return.

There are, however, ethical considerations, as developing regions generally have a historically lower carbon debt than developed counterparts, and have more pressing socioeconomic needs to attend to, which lower discount rates may negatively affect.

One thing is for certain – discounting the need for urgent action on emissions will irreversibly damage not just future economic growth but the survival of our species. Such a reality cannot be discounted.

Robert Bain GradIEMA is an assistant economist at Zero Waste Scotland. To read the article with full source listings visit www.iema.net/articles/the-devils-in-the-discount-detail