Tuesday, February 5, 2013

How Should Benefits and Costs Be Discounted in an Intergenerational Context?

I can see that this paper is going to be important. A paper by Arrow and twelve other authors reporting on a workshop at RFF in 2011 where the EPA asked 12 of the economists how the benefits and costs of regulations should be discounted for projects that affect future generations. This sounds similar to the panel convened in the early 1990s by NOAA on the consensus on contingent valuation that also included Arrow.

The economists all agreed that the Ramsey formula provides a useful framework for thinking about intergenerational discounting. However, they did not agree as to how the parameters of the Ramsey formula might be determined empirically. It seems that they also agree that declining discount rates make more sense than using different rates for projects with different time scales, stating: "Theory provides compelling arguments for a declining certainty-equivalent discount rate." But they think that doing this in the Ramsey framework involves too much uncertainty about parameter values. Therefore, they recommend the approach introduced by Weitzman in "Gamma Discounting". A declining discount rate raises, however, the issue of time inconsistency. They argue that as the discount rate schedule needs to be updated from time to time as new information is available, this updating means that a new decision will need to be made anyway and, therefore, there is no inconsistency. But I think they realise that this is a bit of a stretch.

I've always favored combining sustainability constraints combined with regular discounting to get around these issues. To my mind, anyway, doing a cost-benefit analysis of an issue involving very large changes like global climate change doesn't make economic sense nor moral sense. The problem is better stated as how to stay within the 2 Celsius target (or how to get back within it) at minimum cost (and equitably). And uncertainty should be modeled explicitly rather than built into the discount rate.

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