How long-run discount rates inform climate change policy

From: Blog

Imagine that carbon emissions are expected to cause $5 trillion in damages by the year 2100. Should we act now, or wait to pay that bill?

This is a question that is plaguing governments and policy makers around the world. Part of the problem is that in order to make this decision, we first have to determine how much the future damage will cost in today's dollars. So, for example, if you have $100 in damages today, then it is worth $100 today. But how much will that same $100 be worth in five years, in 100 years, or in 1,000 years? That value is determined by the expected rate of inflation as represented by the discount rate. Unfortunately, most of the ways to determine that are purely theoretical. Until now. 

Chicago Booth Assistant Professor of Finance Stefano Giglio, and colleagues Matteo Maggiori and Johannes Strobel of New York University, found a way to figure out the real cost of things far into the future by looking at leaseholds and freeholds, which are part of the housing market in the UK and Singapore. Leaseholds are temporary ownership contracts that people pay for completely in advance, and hold onto for between 99 and 999 years, and freeholds are permanent ownership contracts. By comparing them, the researchers could figure out how much money today will be worth in hundreds of years.

They discovered that very long-term discount rates are low, very low. This is critical for determining what we need to pay today to take care of tomorrow's problems. So for example, imagine that carbon emissions are expected to cause $5 trillion in damages by the year 2100. According to Giglio, at a discount rate of 3%, it would be worth $383 billion to us today to avoid this damage. On the other hand, a discount rate of 5% would mean that avoiding $5 trillion in damages by the end of the century would be worth only about $72 billion today. 

In many countries, including the United States and much of South America, governments are looking at climate policy and using a 5–10% discount rate to figure out what to invest. According to Giglio and his colleagues, this could be an enormous error—one that will cost future generations, that may be suffering under massive environmental problems, billions or even trillions of dollars when that climate bill comes due.

—Robin Mordfin