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Advice & Dissent: Discounting Our Descendants?

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
January 1993
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Global warming used to be considered an esoteric topic, a matter best reserved for scientists and alarmists. But in recent years, policymakers all over the world have been forced to bone up on this futuristic issue—the possible warming of the earth’s surface from emissions of carbon dioxide (C02 and other greenhouse gases. Although big question marks still surround the extent to which temperatures will rise and the potential ecological and economic ramifications—minor or catastrophic—a consensus has been building for nations to act.

In that spirit, at the June 1992 Earth Summit in Rio de Janeiro, more than 150 countries signed a convention aimed at stabilizing concentrations of these gases. Industrial countries recognized the desirability of returning to their 1990 emissions levels by the year 2000, and a mechanism for deciding on stronger measures in the future, if warranted, was set up. But few specific measures or targets were included, reflecting a widespread disagreement on just how activist nations should be. The stumbling block, as voiced most strongly by the United States, was a paucity of studies that rigorously set out both the costs and benefits (damage avoided) of abating carbon emissions. In actuality, quite a lot had been done on the cost side, but very little had been done on estimating benefits.

For that reason, The Economics of Global Warming, a recently published book by William Cline (see below), with the Washington-based Institute for International Economics (a private, nonprofit institution), has drawn much attention. Using the technique of cost-benefit analysis, it concludes that primarily on economic grounds—with many ecological effects omitted—an “aggressive” action program by nations is warranted. What separates the Cline study from those done by others is the time frame: the analysis extends out to 300 years, far longer than the usual 80-120 years. In addition, Cline advocates the use of a low (about 2 percent) discount rate—that is, the rate at which we translate future net returns into their present value—a controversial proposition, to put it mildly.

Although straightforward when dealing with easily quantifiable expenditures and returns, the cost-benefit exercise loses much of its precision when used to weigh projects aimed at dealing with a narrow set of environmental issues—chiefly, global warming, biodiversity, and resource depletion. One complication is that the market does not put a price on many of the noneconomic benefits (beautiful scenery, for example). Another is that many of these benefits are subject to considerable uncertainty. Still another problem, and this is where the discount rate comes in, is that while the costs under consideration occur now, most of the benefits are far in the future, perhaps even in many generations to come. As a result, even a small change in the discount rate used in a cost-benefit analysis has a tremendous impact on the bottom line. For example, if a 1 percent discount rate is used, $1 million to be received 200 years in the future is worth $140,000 today, but at a 10 percent rate, that same $1 million is worth only one half of one cent (see table).

What a difference a rate makes
Amount of $1Present value of SI
Discount ratecompoundedreceived 200 years
(Annual percentages)over 200 yearsin future
0.01.001.00
1.07.320.14
5.017.293,000.000038
10.0189.900.000.000.00000000527
Source: Cline, The Economics of Global Warming, 1992.
Source: Cline, The Economics of Global Warming, 1992.

This is why some people—especially environmentalists—insist that when it comes to setting the level of the discount rate, long-term investments to protect the environment must be treated differently. They advocate a special low discount rate. Otherwise, they say, no project where the costs are now and the benefits many generations hence will ever survive the cost-benefit test.

Cline, too, advocates a low rate, but for a different reason. He says environmental projects should be treated no differently from other projects. However, if the proper cost-benefit methodology is used, the result—at least for global warming—will necessarily be a low-discount rate.

Others, such as the World Bank, worry that an especially low discount rate would actually reduce the wealth passed on to the next generation by financing projects whose rates of return are lower than those for other available investments. This in turn could reduce the ability or willingness of that generation to allocate resources to environmental protection.

A few economists even propose using an overriding criterion, such as “sustainability” (generally agreed to mean ensuring that present needs are met without compromising future generations). After all, the argument goes, it is a question of equity and resource ownership: we should be obligated to bequeath to posterity not only a certain stock of wealth but also a certain fraction of that wealth in natural capital—which raises questions above and beyond that of simply the discount rate.

As the debate heats up, irrespective of how the earth is doing, Finance & Development thought it a good time to invite Cline and the World Bank—who share a deep concern about environmental issues, but differ on the best way to make decisions that will benefit future generations—to air their views.

Laura Wallace

Assistant Editor

The Economics of Global Warming, Institute for International Economics, 11 Dupont Circle NW, Washington, DC 20036, USA, 1992, xi + 399 pp., $40 ($20 paper).

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