I was over at Realclimate yesterday, researching something entirely different – but related, obviously – when I can across a post referring to the discounting conundrum. I’m afraid to say I couldn’t resist making a contribution and then another one.
I have to say that the more I think about the issue of GW cost discounting, the more I harden my position. It seems to me that valuing the future less than the present has all the characteristics of a self-fulfilling prediction. We should not discount future capital losses compared to present expenditure.
My parting shot over at Realclimate included the ever so slightly controversial claim that:
“…[the cost of GW] damage will increase with GDP, since economic damage caused by GW will be proportionate to the total GDP whenever it occurs (e.g. consider that Stern discusses insurance losses in terms of total global GDP). [Equivalent funds] I invest will also increase with GDP…”
I fully expected this statement to be attacked, so had to have a riposte ready before posting. [Postscript (a few minutes after writing this post): I was wondering if the lack of activity on the Realclimate thread was because the Moderator had had a Bank Holiday lie-in. It now seems this may well have been the case. There’s now more to read over there].
I was worried that people would claim they could obtain a long-term investment return exceeding GDP. No they can’t. The so-called risk-free rate applies to government bonds. If I could achieve a return greater than the growth in GDP, that would imply that by investing in government bonds and reinvesting the return – in effect doing nothing, by definition, since this is the risk-free rate of return we are talking about – I could, over time, grow my wealth as a share of GDP. That would be nonsense. Merv and Gordo are stupid, but not that stupid.
But I now see (thanks to a presentation [pdf] by Mike Hanemann referred to in a Realclimate post) that it is the other side of the equation – my assertion that the cost of damage will increase with GDP – that is where Stern’s discount rate comes from. The Hanemann presentation notes that:
“Factors underlying the interest rate
• Pure rate of social time preference (ρ)
• How much richer the future generation will be (g)
• If they are richer, how much that lowers the value of money to them (η)
• Interest rate is: r = ρ + ηg
– Nordhaus & Stern both use same η (=1) and similar g (= 1.3%)
– Nordhaus uses ρ = 2.3-3%; Stern ρ = 0.1%
– Result is that for Stern r = 1.4%, while for Nordhaus r = 3.6 – 4.3%. “
[If you’re slightly confused that John Broome in Sci Am claims “Nordhaus discounts at roughly 6 percent a year”, then we’re in the same boat].
Nordhaus’ ρ = 2.3-3% is a self-fulling prediction as I’ve already pointed out. We can hardly avoid future catastrophe by, in effect, simply saying it doesn’t matter much.
My basic problem is with the idea that future generations will be “richer”. What does this actually mean? However rich we are, GW has the potential to destroy fixed proportions of our capital. If Cambridge ever disappears into the North Sea, we will lose a proportion of all the capital ever invested in Cambridge whether this happens in 2008, 2058, 2108 or 2808. Residents in New Orleans lost their houses whether these had all mod cons or hadn’t been modified for 50 years. They lost their TVs whether they were 1960s B&W sets or the latest wide-screen hi-def plasmas. Similarly many people in the Irrawaddy delta have lost everything, regardless of how rich they were. We may all have smart ecohomes in 2108, but we won’t necessarily have the capacity to replace them more quickly (actually our capacity to replace housing stock in the UK is slower than it was 50 years ago). The cost of a catastrophic flood in the East of England will be x thousand houses (and y hectares of farmland lost to the sea etc) whatever their nominal value or indeed how much real costs in terms of time and non-salvageable materials have been invested in them.
The idea that we are 1.3% “richer” each year is a bizarre economic construction. We may just have more sophisticated assets to lose in the future, that’s all.
If the whole planet is rendered uninhabitable by GW, it won’t matter how “rich” we are. Similarly if 10% or 1% is lost or degraded (e.g. due to sea-level rise or desertification) this is 10% or 1%, however rich we are.