Max Wilkinson has a go in the Financial Times, complete with an over-the-top headline: Stern's report is based on flawed figures. The issue is Stern's choice of using a discount rate of 2-3% a year to discount the future costs of global warming:
[T]he actual figure used by Sir Nicholas seems to have been between 2 and 3 per cent, less than half the rate that the UK Treasury now uses for assessing large capital projects and much lower than the private sector would expect...
A higher discount rate, predicated on a high economic growth rate and more in line with commercial realities, would discount future costs so that they appear much smaller to today’s consumers and taxpayers. It would make the costs of global warming in 100 years’ time appear small or even negligible in present-day terms.
As far as I can tell, pretty much every structural macroeconomic model makes use of a rate of around 3% to discount future utility. Since there are many reasons to think that an even lower rate is appropriate for an analysis of climate change, it's probably quite sensible to consider slightly lower values as well.
As far as the arithmetic goes, Wilkinson has a point: a higher discount rate would indeed significantly affect the present-value calculations. But there's no earthly reason to think that the proper discount rate is the one used to discount the returns from a capital investment project. The return on those sorts of investments incorporate a risk premium over and above the rate at which the investor discounts future utility. For most investments, that risk premium is positive, since their payoffs are generally positively correlated with movements in consumption. But since the benefits of of addressing climate change are unlikely to have any particular correlation to movements in consumption (i.e., the business cycle), the appropriate risk premium for discounting the benefits of slowing global warming is approximately zero.
Benefits from addressing climate change are negatively correlated (if effective) with wealth, at least in these part of the world most affected by climate change, and possibly with the world aggregate wealth. The risk premium may be negative.
It is very hard to figure the proper discount rate in a world where we don't understand the observed risk premium. However, I conjecture that some of the current explanations for the equity premium based on financial frictions, credit constraint and other market incompleteness would increase the price of risk and magnify the premium.
At the very least, a 3% discount rate is a conservative choice from the author's viewpoint, I'd say.
Posted by: Leon | November 07, 2006 at 10:37 AM
If you follow the stentorian objections of people like R.Tol, the bemused ivoroy tower stuff of Nordhaus, or note who tends to follow whom, it soon begins to seem that the quarrel here is ideological. One Australian economist said that if you really do not give a shit about the future you will hit them on the head with your discount, so if you do care you will head toward zero on this item. But with the two new reports we have recently, one being the Stern review noted here, and the other being the 4th Report (or a pre report summary) of the IPCC on the environmental science side, it is not at all a matter of the distant future. You do not lhave to worry about your grandchildren because you are or soon will be thoroughly concerned about your own rear end. When the climate starts to bite we call it weather, and sensible people get out of the rain.
Posted by: garhane | February 09, 2007 at 06:14 PM