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)

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.

• Item Type: MPRA Paper
• Language: English
• Keywords: Sustainability,economics, environment, Cost-benefit analysis, long-run discount rate
• Subjects: Q - Agricultural and Natural Resource Economics ; Environmental and Ecological Economics > Q5 - Environmental Economics; Q - Agricultural and Natural Resource Economics ; Environmental and Ecological Economics > Q5 - Environmental Economics > Q56 - Environment and Development ; Environment and Trade ; Sustainability ; Environmental Accounts and Accounting ; Environmental Equity ; Population Growth

References

Atkinson, G., Dubourg, R., Hamilton, K., Munasinghe, M., Pearce, D.W and Young, C. 1997. Measuring Sustainable Development: Macroeconomics and the Environment, Cheltenham: Edward Elgar

Barro, R. J., 1999. Ramsey Meets Laibson in the Neoclassical Growth Model. Quarterly Journal of Economics, 114(4), 1125-1152.

Brock W.A., 1977. A Polluted Golden Age. In Smith, V ed, Economics of Natural Resources. New York: Gordan and Breach.

Chichilnisky, G., 1996. An axiomatic approach to sustainable development. Social Choice and Welfare, 13, 231–257.

Dasgupta, P., 2001. Human Wellbeing and the Natural Environment. Oxford: Oxford University Press

Dickey, D.A. and Fuller, W.A., 1979. Distribution of the Estimators for Autoregressive Time Series with a Unit Root. Journal of the American Statistical Association 74, 427--431.

Dybvig, P. and Ingersoll, J. and Ross, S., 1996. Long Forward and Zero-Coupon Rates Can Never Fall’ 69:1 Journal of Business 1-25.

Fisher and Krutilla 1975., ‘Resource Conservation, Environmental Preservation, and the Rate of Discount’. Quarterly Journal of Economics, 89(3) p358-70.

Frederick, S., Loewenstein, G. and O’Donoghue, T., 2002, Time discounting and time preference: a critical review, Journal of Economic Literature, XL, 351–401.

Gollier, C., 2002a. Time Horizon and the Discount Rate. Journal of Economic Theory, 107(2): p463-73.

Gollier, C., 2002b. Discounting an uncertain future, Journal of Public Economics, 85, 149-166

Gollier, C., 2002c. Maximising Expected Net Future Value as an Alternative to Gamma Discounting. Working Paper, Toulouse University.

Gravelle H and Smith D (2000). Discounting for Health Effects in Cost Benefit and Cost Effectiveness Analysis. Centre for Health Economics Technical Paper Series 20. University of York.

Gray, F.S., 1996. Modeling the Conditional Distribution of Interest Rates as a Regime-Switching process. Journal of Financial Economics 42, 27-62.

Groom, B., Koundouri, P., Panopoulou, K., and Pantelides, T., 2003. Model Selection in discounting the distant future. University College London, Economics Working Papers Series, No. 04-02. Downloadable from: http//: www.econ.ucl.ac.uk

Harrod, R., 1948. Toward a Dynamic Economics. Macmillan.

Harvey, A.C., 1993. Long memory in stochastic volatility. Mimeo, London School of Economics.

Heal, G., 1995. Lecture Notes on Sustainability. Memorandum 16. Department of Economics, University of Oslo, Norway.

Heal, G., 1998. Valuing the Future: Economic Theory and Sustainability, New York: Columbia University Press

Hepburn, C., and Groom B., 2004. Uncertain Discount Rates Increase with the Temporal Numeraire. Mimeo. Nuffield College Oxford.

HM Treasury, 2003. The Green Book: Appraisal and Evaluation in Central Government: London: HM Treasury.

Horowitz, J., 2002. Preferences in the Future. Environmental and Resource Economics 21, 241-59.

Hotelling H., 1931. The Economics of Exhaustible Resources. Journal of Political Economy, (39), 137-175.

Kimball, M.S., 1990. Precautionary Saving in the Small and in the Large’, Econometrica, 58, 53–73.

Koopmans, T.C. 1965. On the concept of optimal economic growth, Pontificae Academiae Scientiarum Scripta Varia, 28, 225–300.

Krutilla, J and Fisher, A.C. 1975. The Economics of Natural Environments. Baltimore: Johns Hopkins University Press

Laibson R., 1997. Golden Eggs and Hyperbolic Discounting. Quarterly Journal of Economics.CXII, 443-477.

Li, C. Z., and Lofgren, K. G., 2000. Renewable Resources and Economic Sustainability: A Dynamic Analysis with Heterogeneous Time Preferences’ Journal of Environmental Economics and Management, 40, 236–250.

Li, C. Z., and Lofgren, K. G., 2001. Economic Growth, Environmental Quality and Hyperbolic Discounting. mimeo

Lind, R., 1982. A Primer on the Major Issues Relating to the Discount Rate for Evaluating National Energy Options’, in Discounting for Time and Risk in Energy Policy, edited by R. Lind. Washington, Resources for the Future, 21-114

Little I.M.D. and Mirlees J.A., 1974. Project Appraisal and Planning for Development Countries. New York. Basic Books.

Loewenstein, G and Elster J., (eds) 1992. Choice over time. New York. Russell Sage Foundation.

Loewenstein, G and Prelec, D., 1992. Anomalies in intertemporal choice: evidence and an interpretation, Quarterly Journal of Economics, 107, 573-597

Lucas, R.E., 1977, "Asset Prices in an Exchange Economy," Econometrica 46, 1429-1445

Newell, R and Pizer, W., 2003. Discounting the Benefits of Climate Change Mitigation: How Much do Uncertain Rates Increase Valuations? Journal of Environmental Economics and Management, Vol. 46(1), 52-71.

Pearce, D.W. and Ulph. D., 1999. A social discount rate for the United Kingdom, in Pearce, D.W., Environmental Economics: Essays in Ecological Economics and Sustainable Development. Cheltenham: Edward Elgar, 268–285

Pearce, D., Groom, B., Hepburn, C., Koundouri, P., 2003. Valuing the Future: Recent Advances in Social Discounting. World Economics, 4(2), 121-141.

Pearce, D.W., 2003. The social cost of carbon and its policy implications. Oxford Review of Economic Policy, forthcoming. Phelps E.S., 1961. The Golden Rule of Accumulation: a fable for growthmen. American Economic Review, 638-643.

Pigou A., 1932. The Economics of Welfare, 4th edition, Mac Millan, London.

Portney, P and Weyant, J. (eds). 1999. Discounting and Intergenerational Equity, Washington DC: Resources for the Future

Rabl, A., 1996, Discounting of long term costs: What would future generations prefer us to do? Ecological Economics, 17, 137-145.

Ramsey, F.P., 1928. A mathematical theory of saving. Economic Journal, 38, 543–59.

Weitzman, M. 1994. On the ‘environmental’ discount rate. Journal of Environmental Economics and Management, 26, 1, 200-9

Weitzman, M., 1998. Why the far distant future should be discounted at its lowest possible rate, Journal of Environmental Economics and Management, 36, 201–208.

Weitzman, M., 2001. Gamma Discounting, American Economic Review, 91, 1, March, 261–271.