Thursday, September 20, 2012

Which discount rate?

This week we introduced the concept of discounting in MBA 505.  We approached it strictly from a private sector perspective -- how do households and organizations compare a dollar today with one in the future.  Of course the same concept gets used in public policy analysis.  For instance an investment in workplace redesign to promote safety costs dollars up front but yields long-term benefits, so a discount rate is needed to valuate the future payoff. 

The choice of the proper discount rate can raise some complex issues, as illustrated in a current NYT blog post on climate change.  In 2010 economists, lawyers and scientists from a dozen federal agencies determined that it would be wise to use a consistent discount rate across the board.  After careful analysis and discussion, they settled on 3 percent.  At this rate a ton of carbon imposes a cost of $21 on society (pollution, global warming, etc.). 

This finding has been challenged by a study that argued the real cost was much higher -- $55 to $266.  Why were these numbers so much higher?  Simple answer, the authors used much lower discount rates between 1 and 2 percent. 

The issue boils down to how much value to be place on the welfare of people who have not even been born yet.  On the one hand, we would expect them to be much better off than we are and quite capable of paying for some carbon abatement on their own.  On the other, there is uncertainty about how severe the consequences of global warning might be (which might dictate larger investments in abatement now to prevent Manhattan from turning into another Venice) as well as the ethical issue of taking responsibility for the type of planet we leave to future generations. 

Ultimately politicians and voters will determine whether increased investments in carbon abatement are worthwhile.  Until the economy recovers, I would bet that more people would be using a 3 percent rate than a 1 percent rate. 

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