Faced with the climate emergency and other looming global challenges, the decisions we make today will reverberate across generations. For a new study that emphasizes the pivotal role of the social discount rate in managing our priorities, TSE director Christian Gollier and his coauthors Frederick van der Ploeg and Jiakun Zheng asked a broad sample of economists whether discount rates should be adjusted to the risk profile of public programs. Their survey sheds light on puzzling inconsistencies but also suggests that scientific consensus may be emerging on how to balance our immediate goals with long-term resilience.
What is the social discount rate and why is it important?
The social discount rate is a measure of the relative importance of consequences that occur at different points in time. By putting a present value on the future costs and benefits of projects such as schools, hospitals or solar power subsidies, it allows policymakers to allocate limited resources according to the merits of each initiative. Although this is a widely accepted tool for evaluating investment projects and public policies, there is still much controversy about which discount rate should be used in practice, particularly for the distant future.
Economics cannot provide a complete answer to this question, which involves deep ethical issues. However, the emergence of major challenges to the sustainability of our societies – from climate change and biodiversity to pension-fund liabilities and the reduction of public debt – has put pressure on economists to guide and inform humanity in its choices about how to value long-run costs and benefits. These choices can have huge implications. The present value of $1 million received in 200 years is equal to either $137,000 dollars or $1 depending upon the use of a discount rate of 1% or of 7%, as suggested by different experts.
Why do we need to adjust discount rates for specific projects?
Consider a project to build a hospital. This investment offers insurance value as the hospital will be most useful in the next pandemic, when the economy will suffer. In contrast, building a railway line exacerbates macroeconomic volatility because this project’s greatest benefits will be felt during the next boom, and its smallest benefits in a recession. For this reason, the discount rate for evaluating transport projects and other pro-cyclical investments, especially those that depend on future tax revenues, should include a positive risk premium. Meanwhile, investments which reduce risk – such as hospitals, strategic petroleum reserves, or masks for the next pandemic – should be discounted at a rate smaller than the interest rate.
It is remarkable that most Western countries, apart from France, have opted to use a single discount rate in their policy evaluations. Indeed, most public and private institutions and people use an inefficient discount rate that fails to account for risk, aversion to risk, and hedging possibilities. This can lead to a catastrophic undervaluation of policies that protect society from natural disasters or a pandemic. In a previous study (Gollier, 2021), I find that misallocation of funds resulting from use of a single discount rate could entail a permanent loss exceeding 20% of GDP.
What are the key findings of your survey?
Our main finding is that three-quarters of professional economists believe that discount rates should be adjusted for risk, as recommended by any theory recognizing that stakeholders are risk-averse. These respondents seem to discriminate between projects with pro-cyclical and counter-cyclical benefits. For example, they discount railways more than hospitals and climate mitigation. However, the degree of differentiation is relatively modest given the differences in risk profiles. Combined with the one-in-four respondents who recommend a single discount rate, this suggests that our economic experts want to penalize risky projects far less than financial markets have done over the past century. We call this the “discount premium puzzle”.
There is also a discrepancy between the low discount rate that our respondents use to evaluate the social cost of carbon and the common assumption by climate economists that global warming damages are proportional to aggregate economic activity. These differences may be due to our respondents’ preferences for greener policies, but more research is needed to resolve this conundrum. Similarly, one interpretation of our discount premium puzzle is that respondents believe ethics and pragmatism play a greater role in shaping decision-makers’ risk attitudes than saving and investment decisions in financial markets.
What are the main implications for research and policy?
Our survey shows that economists have learned from the theories developed over the past 50 years to remove the ambiguities surrounding the discounting system. More specifically, the degree of disagreement about the climate discount rate recommended by our respondents is also smaller than the one observed by Weitzman (2021), suggesting some convergence on this controversial topic. The standard theoretical pseudo-justifications for a uniform discount rate have been debunked for a long time now. Although this message has not yet been heard by public decision-makers, our survey shows that a large majority of professional economists think governments should stop using a single discount rate for evaluating public policy.
Article published in TSE Reflect, December 2023