1/18 Reyer Gerlagh EAERE, June 2008 Institute for Environmental Studies Vrije Universiteit Amsterdam The Role of Discounting EAERE annual conference, June 2008, Gothenburg, Sweden Reyer Gerlagh, University of Manchester / VU Amsterdam Philibert Cedric, Greg Hertzler, Michael Hoel, Snorre Kverndokk, Cees Withagen and many others and you

2/18 Reyer Gerlagh EAERE, June 2008 Institute for Environmental Studies Vrije Universiteit Amsterdam Déjà Vu 2006/7, Stern et al.: BAU Climate change damages exceed mitigation costs by magnitude. We need deep GHG emission cuts. Analysis based on almost-zero discounting for ethical reasons 2006/7, Toll & Yohe, Byatt et al., Nordhaus, Dasgupta: Almost-zero discounting is nonsense. E.g., it implies huge savings of man-made capital, which is (i) unrealistic, (ii) bad for the poor, (iii) polluting 2008, Dietz et al. (=Stern team): We stick to our conclusions and our methodology Have we learned nothing since 1992 (Rio de Janeiro, UNFCCC)? 1992, Cline “The economics of global warming”: pure discount rate should be zero, for ethical reasons. 1928, Ramsey: positive pure discounting reflects lack of imagination. 1994, Broome “Discounting the future” 1992, Nordhaus “An optimal transition path …”: pure discount rate should be 3%/yr, otherwise policy is inefficient (=waste of income).

3/18 Reyer Gerlagh EAERE, June 2008 Institute for Environmental Studies Vrije Universiteit Amsterdam The problem “After a century of promoting benefit–cost analysis using net present values, some economists have lost faith. Net present value discounts the long-term consequences of species extinctions, greenhouse gas emissions and nuclear wastes to virtually nothing. This is unacceptable.” (Greg Hertzler)

4/18 Reyer Gerlagh EAERE, June 2008 Institute for Environmental Studies Vrije Universiteit Amsterdam Aim To help those of us who are confused by this seemingly lack of progress to understand the alternative views, so that we can Appreciate literature on hyperbolic discounting, dual discounting, uncertainty, etc. Move towards exchange of arguments, rather than merely stating positions Escape the battle between ‘zero’ and ‘positive’ pure discounting And make a more nuanced choice

5/18 Reyer Gerlagh EAERE, June 2008 Institute for Environmental Studies Vrije Universiteit Amsterdam The Question What is the role of discounting? Descriptive: to provide an consistent framework for inter-temporal efficient decisions To ensure efficiency between policy decisions on different areas? Prescriptive: to provide a consistent framework for inter-temporal ethical decisions To ensure equity between present and future generations? And what does that imply for discounting principles? We will discuss collected propositions on discounting accepting the efficiency perspective (descriptive) discounting based on a more normative stand (prescriptive)

6/18 Reyer Gerlagh EAERE, June 2008 Institute for Environmental Studies Vrije Universiteit Amsterdam Propositions Overview I: descriptive Within the descriptive perspective, we need a more elaborate approach compared to current practice It is rational to use dual discounting with low discount rates for environmental assets that are not substitutable nor reproducible (Philibert Cedric). Not discounting as such, but the risks and consequences of environmental damage is important. We should use real option values (Greg Hertzler + others). Even under perfect foresight, the Ramsey rule does not apply to the aggregate-level and can’t be used for long-term discounting (Reyer Gerlagh)

7/18 Reyer Gerlagh EAERE, June 2008 Institute for Environmental Studies Vrije Universiteit Amsterdam Overview of Propositions II: prescriptive It is not that simple to understand & represent inter-generational preferences The utilitarian perspective with almost-zero discounting is just one (arbitrary) possibility to deal with intergenerational equity. Not necessarily the preferred option (Nordhaus 2006). We should differentiate between intra-personal and inter-personal discount rates (Michael Hoel). Consumers’ pure time preference is not exogenous, but depends on policy (Snorre Kverndokk). It is rational to use dual discounting with market interest rates for short term and ethical interest rates for long-term decisions (Reyer Gerlagh). Researchers be more careful All long-term environmental analyses need substantial sensitivity analysis with regard to the discount rate used (Cees Withagen).

8/18 Reyer Gerlagh EAERE, June 2008 Institute for Environmental Studies Vrije Universiteit Amsterdam Proposition 1. Substitutability It is rational to use dual discounting with low discount rates for environmental assets that are not substitutable nor reproducible (Philibert Cedric). Explanation Environmental assets that cannot be reproduced or substituted will become increasingly valuable. Thus, giving them a value that would grow at a rate slightly below the discount rate solves the problems that discounting discounts environmental damages to zero. Literature: Neumayer 1999; Gerlagh and van der Zwaan 2002, Hoel & Sterner 2007, Sterner and Persson 2008 Implication/importance If this proposal is accepted, “usual” discount rates would not anymore lead to net present values of future environmental damages that seem ridiculously low. The irreplaceable nature of Nature, and the irreversibility of its destruction, would thus be taken in account.

9/18 Reyer Gerlagh EAERE, June 2008 Institute for Environmental Studies Vrije Universiteit Amsterdam Proposition 2: Risk Much more important are the risks and consequences of environmental damage. We should use real option values (Greg Hertzler). Explanation We should not use a small discount rate. Instead, we need real option values that include additional random processes, nonlinearities and irreversibilities. In a world of uncertainty, real option values should replace net present values in all benefit–cost analyses. Then we might adequately invest to protect our future. Literature: Weitzman with fat tails 2007 Implication By truly taking account of the risks, the analysis becomes much more complex, but such is necessary for a well-informed decision.

10/18 Reyer Gerlagh EAERE, June 2008 Institute for Environmental Studies Vrije Universiteit Amsterdam Proposition 3: Aggregation (Ramsey rule exit) Even under perfect foresight, the Ramsey rule does not apply to the aggregate-level and can’t be used for long-term discounting (Reyer Gerlagh). Explanation The Ramsey supposedly holds for an individual’s savings decision, not on the aggregate level. There is not one representative ever-living consumer. When tested empirically, there is no support that in the long-term economic growth is the single most important fundamental determinant for changes in the real interest rate. Demography, social security, and other variables are probably as important as determinants. Literature: Howarth and Norgaard 1992, Gerlagh and Keyzer 2001, Gerlagh and van der Zwaan 2001, Weitzman 2007 Implication If we follow the descriptive approach, we cannot apply the Ramsey rule without admitting there is no empirical support.

11/18 Reyer Gerlagh EAERE, June 2008 Institute for Environmental Studies Vrije Universiteit Amsterdam Summary Propositions 1-3 When accepting the descriptive approach, we should not simply use the Ramsey rule. We should (i) discount environmental assets that we don’t want to loose at a lower effective rate, and (ii) make better assumptions on possible paths for the future interest rates.

12/18 Reyer Gerlagh EAERE, June 2008 Institute for Environmental Studies Vrije Universiteit Amsterdam Proposition 4: Arbitrariness The utilitarian perspective with almost-zero discounting is just one (arbitrary) possibility to frame intergenerational ethics. Not necessarily the preferred option (Nordhaus 2006). Explanation (by myself) Assume we accept there is a problem: ‘descriptive’ discounting justifies too high environmental damages. There is a technical solution: the utilitarian perspective with almost-zero pure discounting. But this does not imply that this is the best solution. In other policy arenas such as health, social security, discrimination, it is not the utilitarian perspective that guides policy, but other principles such as the right for help when health is considered, the right not to have to live in poverty, the right to be treated equally. Implication Other perspectives can offer other solutions. Do future generations have the right for a ‘safe climate’ (precautionary principle), or the right to enjoy a real rain forest? Valuing future welfare is not always needed.

13/18 Reyer Gerlagh EAERE, June 2008 Institute for Environmental Studies Vrije Universiteit Amsterdam Proposition 5: Intra vs inter-personal preferences We should differentiate between intra-personal and inter-personal discount rates (Michael Hoel). Explanation (by myself) Within-person decisions on savings (pension, consumption smoothing) drive (the interest rate on) the capital market (jointly with firm’s investment requirements). People have preferences for intergenerational distribution that are separate of their own savings, and thus, the preferred social level for intergenerational discounting cannot be derived from markets. Implication We should not copy market interest rates and apply them for climate change policy. We should employ different methods to determine inter- personal preferences.

14/18 Reyer Gerlagh EAERE, June 2008 Institute for Environmental Studies Vrije Universiteit Amsterdam Proposition 6: Education lowers discounting Consumers’ pure time preferences are not exogenous, but depend on policy (Snorre Kverndokk). Explanation Ramsey (1928) already wrote that discounting shows lack of imagination. People are more likely to be addicted if their time preference rate is high. Becker and Mulligan (1997) assume that individuals can invest in goods or activities, such as schooling, to reduce this rate and analyze the implications. This insight broadens the set of instruments available to policy makers, and it should be considered in a cost-effective climate policy. But is it ethically right to influence somebody’s time preference rate? This may be hard to answer, but a lower time preference rate increases the NPV value of life and is considered to be to the benefit of the individual. Implication Educational programs may form an effective part of climate change policy. There are many other positive benefits to education, but this is an unexpected extra. (also: rethinking the purpose of aid)

15/18 Reyer Gerlagh EAERE, June 2008 Institute for Environmental Studies Vrije Universiteit Amsterdam Proposition 7: Dual discounting is rational It is rational for governments to use dual discounting with market interest rates for short term and ethical interest rates for long-term decisions (Reyer Gerlagh). Explanation When the current government saves more (borrows less), the next government can easily cash by lowering taxes and spending the savings. No government can commit the next government to its long-term savings plan (cf US). Lack of commitment implies a higher discount rate for public savings decisions. When the government cuts emissions, the next government cannot turn past abatement costs into current cash. Instead, the benefits will surely reach the intended future generations. Thus, each government can make its own decision on the true long-term preferences without worrying about the intermediate governments (simplification). Implication Given imperfect commitment, optimal policy may be dynamically inefficient (dual discounting) when perceived from first-best, but still be time consistent and optimal within institutional boundaries.

16/18 Reyer Gerlagh EAERE, June 2008 Institute for Environmental Studies Vrije Universiteit Amsterdam Summary Propositions 4-7 When accepting the prescriptive approach, we do not need to use the Ramsey rule with an almost-zero pure rate of time preference. We should (i) try to find out in what way people care about the far future, (ii) where required accept different discount rates for different assets based on our understanding of feasible policy commitment, and (iii) educate the people.

17/18 Reyer Gerlagh EAERE, June 2008 Institute for Environmental Studies Vrije Universiteit Amsterdam Proposition 8: Sensitivity analysis needed All long-term environmental analyses need substantial sensitivity analysis with regard to the discount rate used, including descriptive and prescriptive discount rates (Cees Withagen). Explanation Seems very much common sense, but watch out. The proposition states that the sensitivity should involve both ‘descriptive and prescriptive discount rates’. "Ignoring realities in adopting 'principles' may lead one to search for a nonexistent optimum, or to adopt an optimum that is open to unanticipated objections." (Koopmans 1965: On the concept of optimal economic growth) Implication More information, but also confused policy makers?

18/18 Reyer Gerlagh EAERE, June 2008 Institute for Environmental Studies Vrije Universiteit Amsterdam [Your Proposition] Suggestions for further discussion?

19/18 Reyer Gerlagh EAERE, June 2008 Institute for Environmental Studies Vrije Universiteit Amsterdam Thank You