What are social discount rates?

What are social discount rates and what is their relevance to climate change?

Social discount rates (SDRs) are used to put a present value on costs and benefits that will occur at a later date. In the context of climate change policymaking, they are considered very important for working out how much today’s society should invest in trying to limit the impacts of climate change in the future. In other words, they calculate how much guarding against future carbon emissions is worth to us now, weighing up the benefits future generations would experience against the costs that today’s society would have to bear.

How are social discount rates calculated?

There are two reasons for discounting the future. The first is because it is assumed that societies will grow wealthier over time due to economic growth and therefore a dollar today is worth more than a dollar in the future, when we will enjoy higher incomes. The second, and more controversial, reason is to take account of pure time preference (or impatience). This describes people’s propensity to prefer income today rather than tomorrow, even if they expect to be no more or less rich tomorrow. The controversy stems from whether this feature of people’s attitudes to time should be reflected in policymaking. When applied to inter-generational problems it effectively weighs future generations lower than the present generation.

It is now widely accepted that there is a need to use social discount rates that decline over time, increasingly giving more weight to future generations (see Freeman and Groom, 2016 and Arrow et al, 2013). There are different theoretical arguments for using declining rates, and therefore recommendations on how fast the discount rate should decline also differ. However, perhaps the most popular argument derives from the fact that future economic growth is uncertain (for example, see Weitzman, 2001 and Gollier, 2002).

Why are social discount rates contested?

Social discount rates are important in calculating the benefits and costs of limiting future climate change, because carbon dioxide has a very long residence time in the atmosphere, which means that we must value the impacts of today’s emissions centuries into the future.

The use of a high discount rate implies that people put less weight on the future and therefore that less investment is needed now to guard against future costs. Indeed, high discount rates have been described as favouring arguments against regulations to reduce greenhouse gas emissions. The use of a low discount rate supports the view that we should act now to protect future generations from climate change impacts. In other words, more importance is given to future generations’ wellbeing in cost–benefit analyses.

The results of a survey of economists published in 2015 indicate that most favour a low rate: more than three-quarters of the 200 experts were comfortable with a median SDR of 2%. There is also support for the view that discounting may have a less important role in cost–benefit analysis of climate change than once thought (see, for example, Dietz and Matei, 2016). This is because, as highlighted by Harvard economist Martin Weitzmann, in the case of catastrophic climate change, the severe consequences would override the effect of discounting (see Weitzman, 2009 and Milner, 2013), however low the probability of such an event.