Valuing Climate Damages Updating Estimation of the Social Cost of Carbon Dioxide (2017) / Chapter Skim
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6 Discounting Module
6 Discounting Module
Pages 157-184
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From page 157... ...
The second section looks broadly at approaches to discounting. The next two sections elaborate on likely correlations among climate damages, economic growth, and the appropriate discount rate and the idea that such correlations could be explicitly modeled in the SC-CO2 estimation.
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From page 158... ...
To understand how the discount rates and damage estimate combine to form different SC-CO2 estimates, Figure 6-2 shows the committee's computation of the present value of damages shown in Figure 6-1 using FIGURE 6-1 Undiscounted damages from 1 metric ton of CO2 emissions in 2015 and present value of $1 received in the future using discount rates of 2.5, 3.0, and 5.0 percent. NOTE: See text for discussion.
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From page 159... ...
First, for a given pattern of damages, the SC-CO2 is much higher for low discount rates. Second, the modeling horizon needed to include most of the discounted damages varies with the discount rate.
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From page 160... ...
OMB Guidance on Discounting In RIAs of federal rules, the rate at which future benefits and costs are discounted can determine whether the net present value of a regulation or project is positive or negative. In accordance with OMB Circular A-4, for rules with both intra- and intergenerational effects, agencies traditionally use constant discount rates of 3.0 and 7.0 percent, as well as a possible lower rate to reflect important intergenerational costs and benefits.
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From page 161... ...
It is also the case that the costs and benefits of a project are not always expressed in consumption equivalents. These factors are why OMB requires projects involving intragenerational benefits and costs to be evaluated using discount rates that reflect both approaches, as a sensitivity analysis.
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From page 162... ...
Even when climate damages do not directly affect consumers, damage estimates from the SC-IAMs are reported in consumption-equivalent units. In contrast, the prescriptive approach is based on a social welfare function that reflects the weight that a policy maker attaches to the utility of current and future generations.
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From page 163... ...
This interdependence suggests that the rate used to discount future climate damages needs to be consistent with assumptions about the rate of economic growth that underlie the emissions path in the socioeconomic module and the calculation of climate damages in the damages module. Arguments for adopting the Ramsey-based welfare approach to discounting include the notion that the discount rate ought to be derived from ethical considerations reflecting society's views concerning consumption tradeoffs across generations.
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It identifies a range of implied discount rates from 1.4 to 6 percent: see Table 6-1. Uncertainty about Future Discount Rates Over long time horizons, the discount rate is uncertain.
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bOMB uses a descriptive approach. SOURCE: Adapted from Intergovernmental Panel on Climate Change (2014c, Table 3-2)
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. In this case, the shape of the Rt path depends on the distribution of the per-period discount rates, {rτ}.
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From page 167... ...
. If growth is subject to independently and identically distributed shocks, this term will reduce the discount rate, but not cause it to decline.13 If random shocks to growth are positively correlated over time, however, the precautionary term in the Ramsey formula may become sizable in absolute value for long horizons, leading to a declining term structure of discount rates (see Gollier, 2012, for an extended survey)
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From page 168... ...
and presented results conditional on each of these discount rates. The central value of a 3.0 percent rate, consistent with the consumption rate of interest in OMB Circular A-4 guidance, is meant to reflect the post-tax, risk-free interest rate.
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From page 169... ...
. CONCLUSION 6-1 In the current approach of the Interagency Working Group, uncertainty about future discount rates moti vates the use of both a lower 2.5 percent rate and higher 5.0 per cent rate, relative to the central 3.0 percent rate.
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From page 170... ...
The discount rates applied to CO2 benefits from emission changes in a snapshot year are 2.5, 3.0, and 5.0 percent (plus the 95th percentile for the 3.0 percent rate) , following guidance from the IWG Technical Support Document (Interagency Working Group on the Social Cost of Carbon, 2010)
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From page 171... ...
But if they are correlated, a covariance term arises: it will be a negative effect in the case of positive correlation, lowering the expected net present value of damages, and positive in the case of a negative correlation, thus raising it. For a variety of reasons discussed below, uncertain future climate change impacts may well be correlated with uncertain future discount rates.
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In this Ramsey-style model, the analysis implies both alternative magnitudes of climate impacts and alternative discount rates. In more recent work looking at the SC-CO2 estimates, Nordhaus (2011)
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From page 173... ...
provides an alternative framework for considering the same set of issues through a standard consumption-based capital asset pricing model. In this framework, the appropriate rate for discounting future climate change impacts is rt = rft + bpt , where rt is the discount rate used to discount period t to the present, rft is the risk-free rate over this period, πt is a measure of uncertainty about future average consumption growth over this period, and β is a measure of how future climate impacts vary with consumption.18 As above, persistent uncertainty about consumption growth leads to a declining risk-free term structure, reflected in a declining value of rft over longer horizons.
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As Gollier and Hammitt (2014) note, whether one effect or the other is dominant is "exploratory and controversial." RECOMMENDATION 6-1 The Interagency Working Group should develop a discounting module that explicitly recognizes the uncertainty surrounding discount rates over long time hori zons, its connection to uncertainty in economic growth, and, in turn, to climate damages.
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From page 175... ...
Based on the Ramsey formula, the appropriate discount rates for the 1.0 percent, 2.2 percent, and 3.3 percent growth scenarios are, respectively, 2.0 percent, 3.0 percent, and 4.0 percent. With these assumptions, the committee calculated discount factors for each growth scenario, which are shown in Figure 6-4, along with the average discount factor for each future year assuming equal weights on the scenarios.
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From page 176... ...
The decline in the certainty-equivalent rate from 3.0 percent in 2015 to 2.4 percent in 2295 is a direct implication of allowing the rate of per capita consumption growth to be uncertain. Rather than using uncertain future discount rates to motivate a lower, fixed discount rate as the IWG did in its rationale for a 2.5 percent rate, allowing the rate of growth in consumption to be uncertain explicitly models that behavior.
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From page 177... ...
TABLE 6-2 Expected Discount Factor Based on Example Scenarios and Corresponding Certainty-Equivalent Discount Rates Discount Factors and Discount Rates 2015 2035 2055 2075 2095 2115 2135 2155 2175 2195 2215 2235 2255 2275 2295 Average 1.00 0.56 0.32 0.19 0.11 0.071 0.044 0.028 0.018 0.011 0.0074 0.0048 0.0032 0.0021 0.0014 Discount Factor Certainty- 3.0 2.9 2.9 2.8 2.8 2.7 2.6 2.6 2.6 2.5 2.5 2.5 2.4 2.4 2.4 Equivalent Rate (in %)
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From page 178... ...
The lower discount factors (associated with higher discount rates) for high-growth scenarios largely offset the higher damages associated with those same high-growth scenarios.
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From page 179... ...
It is worth noting that the simulations described in the preceding section with δ and η chosen as normative welfare parameters may not lead to rates that are comparable to observed discount rates. Alternatively, one could choose those parameters to match empirical features of observed interest rates and the long-term relationship between interest rates and economic growth (as in Nordhaus, 2014)
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From page 180... ...
could be presented to reflect other sources of uncertainty in the computation of the SC-CO2. RECOMMENDATION 6-2 The Interagency Working Group should choose parameters for the Ramsey formula that are con sistent with theory and evidence and that produce certainty equivalent discount rates consistent, over the next several decades, with consumption rates of interest.
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From page 181... ...
An implication is that, if the central parameterization for discounting is associated with a near-term 3.0 percent rate, as in the current IWG approach, then the low and high values would be on either side of 3.0 percent. RECOMMENDATION 6-3 The Interagency Working Group should be explicit about how the SC-CO2 estimates should be combined in regulatory impact analyses with other cost and benefit estimates that may use different discount rates.
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From page 182... ...
OTHER DISCOUNTING ISSUES Time Consistency and Uncertain Discount Rates One objection frequently made to the use of a declining discount rate is that it may lead to problems of time inconsistency. Time inconsistency refers to a change in expected net benefits due solely to the passing of time.
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From page 183... ...
Using region-specific discount rates requires values of δ and η for each region, as well as a distribution over the rate of growth of per capita consumption in each region. Treating future generations differently based on where they live -- whether due to differing values of δ and η or to differing growth rates -- suggests a need to treat current generations differently on the basis of where they live.
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