First off, why would we want to delve into such a dry economic concept as the discount rate? Well, as we already saw in the part on defining sustainability, the discount rate determines the intergenerational well-fare to a very large degree. It therefor directly determines economic policy and the actions that are taken today. As we will see below, there can be major consequences through the choice of value for the discount rate and a real challenge is that the discount rate is to some degree subjective involving aspects of morale and personality.

Valuing the future is about how we discount the future. The “right” numerical value of the discount rate is a source of much discussion. A blunt approach is simply to use the current economic discount rate, e.g. used by federal banks. This implies that any amount of money (or time that could have been spent earning money) could instead have been invested in a bank account to receive the benefit of the interest rate over time. On the other hand, one can argue that for public goods (such as biodiversity, climate stabilization, poverty alleviation), future value should be equal or even higher than contemporary value in order to promote sustainable development and for ethical responsibility towards future generations. So, do we use a positive, negative or zero discount rate? A positive discount rate is appropriate for infrastructure that has a limited technical life-time, whereas investments in natural capital have no such inherent limitation. Furthermore, investments in natural capital and poverty alleviation can be regarded as a transfer of wealth to the future, rather than an investment to enhance the wealth of the present generation. If we believe future generations should be at least as wealthy as we are today it makes sense to use zero discount rate for such investments. Doing so will make these investments in sustainable development look more profitable in economic analyses, because future benefits are not discounted. In his famous study from 2006, Nicholas Stern used a lower than usual (but not zero) discount rate on investments for reducing fossil fuels and was therefore able to show that this kind of investment would be very profitable.

The discounting debate

A sure sign that sustainability is to a large degree an ethical question can be traced by the very active debate on how to value future costs and benefits. The debate was invigorated by the Stern review that attempted to provide a cost analysis for climate change impact. This was done to support decision making about whether the reduction of future costs due to climate change could be justified by the perceived high cost of immediate mitigation investments, i.e. answering the question: is it economically effective to curb climate change today in order to avoid future costs?

Since we can be almost certain that the future costs will be much higher than potential remedies today it begs the question why this is an issue at all. The reason lies in how we perceive the future. There are at least two aspects to this: First, uncertainty about the future. Do we know what will happen? How will economic development proceed? how big will the climate impact will actually be? and more importantly will we live to see the future? Secondly, IF we know all this, how much is some benefit worth today if you would receive it some time in the future? This last point is also highly subjective and depends on the framing and context of the question. For example:

• How much would I have to give you in one year for you to wait that time if you could instead get 1000SEK today?
• How much would I have to give you in one+10 years for you to wait that time if you could instead get 1000SEK in ten years?
• How much would I have to give your children in 20 years for you to decline an offer of 1000SEK today?

If you can imagine a number for each of these 3 questions you could calculate your own discount rate and most likely, it would differ between each of the three scenarios. Thus, we can state that the value of the future depends on who makes the decision, who gets the benefits, and the time scale of the problem.

Let us look at these questions by looking more deeply into the vibrant debate following the Stern report:

The discounting formula

National economics generally uses a formula for the discount rate based on the “Ramsey” equation:

Where d is the social discount rate, g is the pure rate of time preference, n determines the relative importance of economic growth, C. The higher the d value that we end up with, the less importance is placed on future costs or benefits. There are two main terms, the rate of pure time preference, g, and the wealth-based component, n C. The first one asks an ethical question: how important are future generations compared to the current one? Zero would mean of equal importance, negative would mean more important and positive would mean less important.

Stern argued for equal worth, equal rights and living conditions for all generations of people, implying that the pure time preference should be zero. However, he added a small term of 0.1% to account for the fact that potentially, humans might not even exist in the future due to manmade or natural disasters! Other economists argue that the pure time preference can be revealed by our current behavior, i.e. if g would really be zero, wouldn’t we save a lot more of our current income for the future?

Partha Dasgupta frames the “Ramsey” equation in a somewhat different way: He suggest thinking of, g, as the tradeoff between current and future generations, and n to be the tradeoff between the rich and the poor, a higher, n, meaning a greater discern for the poor. Note, however, that a higher n in conjunction with a high growth rate of the economy gives a higher total discount rate. Thus, even though we try to be more equitable by choosing a higher, n, we would actually invest less in the future since we value it lower! This comes from the fact that due to the assumption of economic growth, future generations will be “richer” than we are today, thus we can compensate for this by investing less in the future. BUT this hinges on a crucial assumption: positive economic growth. What if we have reached peak-growth? What if the effects of the Great Acceleration are now catching up, reducing the total production base and creating a world in which the economy is constant or even reduces? This will largely depend on how we calculate economic growth; particularly whether we include social and environmental stocks as we have discussed in the previous sections. In fact, if the economy would start to shrink, the total discount rate might easily become negative suggesting that we should invest heavily now for the future.

Kenneth Arrow, a Nobel laureate in economics adds to the debate that according to the calculations in the Stern report, climate mitigation would be efficient as long as the discount rate is less than 8.5%, which is higher than most suggest. Creating a debate about exact numbers seems somewhat obsolete in the face of actually getting to work.

There remain to be questions surrounding the debate on pure time preference. In response to supporters of higher pure time preferences, Stern suggests that the result of a time preference even as large as 1.5% would be basically be the same as anyone with grandchildren telling them that their lives are only half as important as your own.

Contributors: Jon Norberg