Cameron Hepburn

Use of Discount Rates in the Estimation of the Costs of Inaction with Respect to Selected Environmental Concerns

OECD Environment Directorate, ENV/EPOC/WPNEP(2006)13/FINAL, 2007

Discounting is the practice of attaching a lower weight to future costs and benefits than to present costs and benefits. The use of high discount rates can appear to offend notions of sustainable development and the interests of future generations. However, not discounting — using a consumption discount rate of zero — is economically illogical and produces perverse results. Furthermore, although often promoted for environmental reasons, using low or zero consumption discount rates does not necessary lead to greater environmental protection. Zero discounting favours any project with large upfront costs and benefits further in the future, such as road building and investments in long-lived coal-fired power stations. Discounting (and cost-benefit analysis) is intended to ensure that public funds are directed to the projects which yield the greatest social benefits, or which are “efficient”. Recent developments in discounting theory, which incorporate the impact of long-term economic uncertainty, reduce the tension between efficiency and fairness between generations. Never has Keynes’ (1936) dictum about practical men being slaves of “some defunct economist” been more inapt. The key economists are still alive, and impressively, these theoretical developments have been rapidly digested and incorporated into the government guidance of two OECD countries — France and the United Kingdom. Other OECD countries should consider following suit.
Within one country, different government departments should follow the same discounting guidance. Project-specific differences should not be accounted for by ad hoc adjustments to the discount rate. (For example, differences in project risk should be addressed by determining certainty-equivalent project cash flows, not by adjustments to the general discount rate.) When departments use different discount rates, public funds are not allocated efficiently. For instance, suppose an environmental ministry (incorrectly) fails to discount costs and benefits (that is, it employs a zero discount rate), and suppose another ministry applies a positive discount rate to the environmental impacts. The result is that the same environmental impacts would be valued differently, depending artificially on the relevant ministry. To avoid this state of affairs, countries should provide clear and uniform central guidance to all departments. This paper reviewed current discounting practice in the OECD. It found a wide variance in guidance across countries (which may or may not be justifiable by different economic conditions), and significant differences in guidance within countries. Furthermore, even when discounting guidance is specified, it is not always followed in practice. A clear conclusion from this study is the allocation of public funds would be substantially improved if OECD countries provided departments with a consistent set of guidance on discounting. This guidance should provide for the analysis of long-term projects, programmes and policies, which are increasingly important, particularly with respect to environmental concerns. Finally, guidance should incorporate advances in theory of discounting under long-term uncertainty. A recipe for determining the appropriate rate of decline in the discount rate is included in this paper.