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Sustainability and the Economics of the Environment: Cost-Benefit Analysis and the Dynamics of the Long-Run Discount Rate

Koundouri, Phoebe and Groom, Ben (2009): Sustainability and the Economics of the Environment: Cost-Benefit Analysis and the Dynamics of the Long-Run Discount Rate. Published in: Focus on Ecology Research (2009)

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Abstract

This paper reviews the arguments for and the implications of employing Declining Discount Rates (DDRs) in CBA and in the analysis of economic growth and sustainability. We show that there exist several growth models in which a relationship has been found between the long-run equilibrium under DDRs and that in which a zero discount rate is employed. This can have the effect of pushing the optimum under DDRs away from the conventional utilitarian outcome towards the Green Golden Rule (GGR) level of capita or environmental stocks. Furthermore, in response to worries that the GGR places weight on the future at too great an expense to the present, we highlight the result of Li and Lofgren (2000): DDRs can evoke a solution to resource management problems in which the objective function explicitly takes into account the preferences of present and future generations, such as those posited by. Either zero or conventional discounting does not achieve this solution. It is in these senses that DDRs can be seen to encourage a more equal treatment of generations and promote sustainable outcomes. We also discuss different methodologies for the estimation of a working schedule of DDRs assuming that future discount rates and the past provides information about the future. The policy implications of this are that a correctly specified model of discount rates provides a schedule of DDRs, which values atmospheric carbon reduction 150% higher than conventional exponential discounting, and almost 90% higher than incorrectly specified models. In this sense sustainable outcomes are more likely to emerge from project appraisal with DDRs, but given that the theory of DDRs for CBA reviewed relates to the socially efficient discount rate, such outcomes can also be thought of as efficient.

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