December 2012

Volume 21, Number 12

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Discount Rates: Pricing Future Environmental Costs Today

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As natural barriers fell and infrastructure flooded in the path of Superstorm Sandy, some analysts suggested the need for a $10 billion seawall for New York City. While that particular proposal is likely to be an ecological disaster (reestablishing natural wetlands would make more sense) the idea of making investments now to forestall future climate catastrophes was getting a moment in the spotlight—for a New York minute, at least.

How should present-day investments be evaluated in the context of far-off catastrophe? Fortunately, economics gives us useful tools to answer that question; unfortunately, they are plagued by rosy assumptions.

If you had the choice of being given $100 today versus being given $100 in one year, you’d almost certainly take the money today, right? Economically, that would be a rational choice in part because you could invest the money now and have more than $100 in a year.

If you were able to invest that $100 in a bank account with a 7% interest rate, then you’d have $107 in a year. You would have to be given $107 in a year to equal the value of being given $100 today.

While most people are familiar with interest rates, discount rates are more abstract. The discount rate is like a reverse of the interest rate: it tells you how much you should be willing to pay today to have $107 in one year. The answer depends on how much interest you expect to earn on your investment. If you expect to earn 7% interest, then you should pay $100 today for the $107 in the future—and your discount rate turns out to be 7%.

If it’s certain that in exactly 100 years a storm will wipe out $100 billion of buildings in New York City, how much is it worth paying today to prevent that? In the context of the discount rate, how much would you be willing to pay today to realize a payoff of $100 billion in 100 years? If your discount rate is 7%, as many U.S. government models assume, the answer is a measly $115 million. By that measure, you’d be grossly overpaying for that $10 billion seawall: you’d be better off investing your $10 billion at 7% compound interest and bequeathing your descendants $867 trillion dollars, allowing them to easily pay for any storm damage out of pocket. Inflation and other real-world factors lead to more complicated calculations, but you get the picture.

But is it realistic to assume that you could earn 7% annually on your money for the next 100 years when most savings accounts today pay almost no interest, and even a 30-year U.S. Treasury Bond pays less than 3%? At a 3% discount rate, spending $5 billion today to save $100 billion in 100 years is a good investment. If the storm strikes in 10 years instead of 100, then $10 billion now would be a massively successful bet: in fact, paying as much as $74 billion now to save $100 billion in 10 years makes sense at a 3% discount rate.

Given that economic losses from rising sea levels and catastrophic storms could add up to trillions of dollars over the next century, and given the way rates of return on investment have stalled in recent years, it may make good economic sense to think of our descendants and start making some hefty investments in forestalling climate change.

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November 29, 2012