Discounting the Benefits of Climate Change Mitigation
Eileen Claussen, President, Pew Center on Global Climate Change
How do we compare the costs of greenhouse gas mitigation measures taken today with the benefits produced by these actions in the future? How do we calculate the value of an investment when benefits will continue to accrue over centuries? These are important questions, because the way we value the benefits of mitigation measures will guide us in developing cost-effective solutions to the threat of climate change. This report highlights one important variable in this determination that is often left unexamined in current climate change models-uncertainty in future interest rates.
Underlying existing climate change models is a specific set of assumptions regarding emissions levels, economic growth and flexibility, technological innovation, climate change policies, and the magnitude of climate change damages. Though this set of assumptions varies from model to model, each includes a discount rate, which is used to compare costs and benefits over time. The discount rate tells us how high future benefits need to be to justify spending a dollar today. While there is considerable debate regarding the appropriate discount rate to apply to any cost-benefit analysis conducted across generations, most climate models choose one rate (2-7 percent is a common range) and hold it constant over the time horizon of the model.
This study questions that conventional approach. Rather than assuming that interest rates remain fixed over hundreds of years, authors William Pizer and Richard Newell argue that future rates are uncertain. Using an integrated assessment model of climate change, they demonstrate that acknowledging uncertainty about future rates will lead to a higher valuation of future benefits-regardless of the initial rate one chooses. This is a significant finding, because it reveals that including the effect of interest rate uncertainty could raise valuations by as much as 95 percent relative to conventional discounting at a constant rate. In other words, changing the approach to discounting in this manner results in significantly higher projected benefits of addressing climate change.
This report is the first to be published as a technical report in the Pew Center's economics series. The results of this and other ongoing Pew Center analyses will be incorporated into a dynamic general equilibrium model in order to produce a set of model estimates that better capture the full complexity of the climate change issue.
The Pew Center and authors would like to thank William Cline, Ev Ehrlich, and Randy Lyon for commenting on previous drafts of this report. The authors would also like to recognize Michael Batz for research assistance and Andrew Metrick and participants in seminars at the 2000 NBER Summer Institute and 2000 American Economic Association meetings for helpful comments on previous versions of this paper. Greater technical detail on the approach and results described in this paper are given in Newell and Pizer (2000).