What is a really feasible discount rate? The issue of choosing a discount rate, for example in models predicting costs of climate change, is not easy. There is also a risk that one may choose a discount rate that is too low, which would cause us to instead overestimate the costs. Pondering these questions easily makes one think of an accessible paper by William Nordhaus written in 2007 in which he argues that the Stern Review on the Economics of Climate Change uses a discount rate that is too low. Nordhaus claims that the Stern Review’s estimate of overall costs of climate change being equal to the world losing 5% of global GDP each year from now on is dependent on a near-zero discount rate and a very specific utility function.
In this debate there are several relevant perspectives. One of them is economic. In some cases we might actually underestimate the costs, for example when it comes to permanent losses of biodiversity. On the other hand, in other cases we risk overestimating costs, often due to undervalue the rate of technological and economic progress.
The issue of discounting does also have a clear philosophical dimensions. How much are future generations worth? As long as there is an existing risk of extinction of our species there should probably be some form of discount rate due to this uncertainty. But how large should this discount rate be? What is appropriate? How much is the generation of our children worth? And what about their children?
One could also raise the inconvenient question of whether it would be easier for future generations to pay for the harm we cause the environment simply because they likely will be much wealthier than people living today. This argument is one that was discussed by The Economist in a summary of the “Stern-Nordhaus debate.”
A little more recently, Larry Karp has done some interesting research on discounting, and he finds that discounting over time is not constant. This is usually called “hyperbolic discounting,” which implies that our discounting preferences are dependent on the time frame, and generally we are willing to spend almost as much on our great great grandchildren’s generation as on our great grandchildren’s generation because it is so far into the future. This would imply a non-linear relationship over time, as opposed to the linear and time-consistent relationship that is usually assumed. This is an example of how experimental evidence and psychological insights, pioneered by Daniel Kahneman and others, can contribute to economic theory. Hyperbolic discounting is likely to be a topic paid much attention over the coming years.
And finally, two other recommended readings on the choice of discount rate are a blog post by Gary Becker, and a more recent working paper by Lawrence H. Goulder and Roberton C. Williams III.
The so-called environmental Kuznets curve (named after economist Simon Kuznets) is based on a hypothesis that environmental quality and economic development are related in such a way that their relationship produces an inverted-U curve. Supposedly, countries with lower levels of income emit low levels of pollutants. When they industrialize and become richer their emissions will increase up to a certain point when countries either start to invest in the environment or switch to less resource intensive means of production, which leads to falling emissions. In a graph where emissions are plotted on the vertical axis and economic development (usually income per capita) is plotted on the horizontal axis, this would lead to a curve resembling an inverted U. The empirical evidence for the existence of such a curve is mixed. Richard Carson finds that it is in fact effective regulation and diffusion of technological change that cause environmental quality to go up, and that these two factors are associated with higher income levels. If Carson is correct, it would imply that the underlying reasons behind an environmental Kuznets curve are all but clear.
A very simple empirical test also casts doubts on the existence of such a curve. For this test all data available in the World Bank’s database – in total for 68 countries – was used to estimate the relationship between so-called biochemical oxygen demand (BOD), and income per capita (in purchasing power parities (PPP) and constant international dollars). BOD refers to the amount of oxygen that bacteria in water will consume in breaking down waste. This is a standard water-treatment test for the presence of organic pollutants. BOD satisfies both the condition of being a local pollutant and of having short-term costs – two conditions normally claimed to be required for an environmental Kuznets curve to exist.
In a linear regression test with time-lag, PPP per capita is associated with a reduction in BOD a decade later. However, when a quadratic term for PPP is introduced into the model, it seemed as if the relationship was quadratic rather than linear. But in sharp contrast to environmental Kuznets curves, this relationship is plotted as a normal U, not an inverted one. This test thus suggests an “inverted environmental Kuznets curve.”
It should be noted as a significant caveat that data on both BOD and PPP are sketchy, but this test at least suggests that BOD falls sharply with higher levels of income per capita until a certain point when BOD starts rising again. It could be something worth looking into further.