Abstract: In September 2011, the US Environmental Protection Agency asked 12 economists how the benefits and costs of regulations should be discounted for projects that affect future generations. This paper summarizes the views of the panel on three topics: the use of the Ramsey formula as an organizing principle for determining discount rates over long horizons, whether the discount rate should decline over time, and how intra- and intergenerational discounting practices can be made compatible.The panel members agree that the Ramsey formula provides a useful framework for thinking about intergenerational discounting. We also agree that theory provides compelling arguments for a declining certainty-equivalent discount rate. In the Ramsey formula, uncertainty about the future rate of growth in per capita consumption can lead to a declining consumption rate of discount, assuming that shocks to consumption are positively correlated. This uncertainty in future consumption growth rates may be estimated econometrically based on historic observations, or it can be derived from subjective uncertainty about the mean rate of growth in mean consumption or its volatility. Determining the remaining parameters of the Ramsey formula is, however, challenging.

Abstract: Should governments, in discounting the future benefits and costs of public projects, use a discount rate that declines over time? The argument for a declining discount rate is a simple one: if the discount rates that will be applied in the future are persistent, and if the analyst can assign probabilities to these discount rates, this will result in a declining schedule of certainty-equivalent discount rates. A growing empirical literature estimates models of long-term interest rates and uses them to forecast the declining discount rate schedule. I briefly review this literature, focusing on models for the United States. This literature has, however, been criticized for a lack of connection to the theory of project evaluation. In cost-benefit analysis, the net benefits of a project in year t (in consumption units) are to be discounted to the present at the rate at which society would trade consumption in year t for consumption in the present. With simplifying assumptions, this leads to the Ramsey discounting formula. The Ramsey formula results in a declining certainty-equivalent discount rate if the rate of growth in consumption is uncertain and if shocks to consumption are correlated over time. Using the extended Ramsey formula to estimate a numerical schedule of certainty-equivalent discount rates is, however, challenging.

Abstract: Nearly all discussions about the appropriate consumption discount rate for climate change policy evaluation assume that a single discount rate concept applies. We argue that two distinct concepts and associated rates apply. We distinguish between a social-welfare-equivalent discount rate appropriate for determining whether a given policy would augment social welfare (according to a postulated social welfare function) and a finance-equivalent discount rate suitable for determining whether the policy would offer a potential Pareto improvement. Distinguishing between the two rates helps resolve arguments as to whether the choice of discount rate should be based on ethical considerations or empirical information (such as market interest rates), and whether the discount rate should serve a prescriptive or descriptive role. Separating out the two rates also helps clarify disputes about the appropriate stringency of climate change policy. We find that the structure of leading numerical optimization models used for climate policy analysis may have helped contribute to the blurring of the differences between the two rates. In addition, we indicate that uncertainty about underlying ethical parameters or market conditions implies that both rates should decline as the time horizon increases.

Abstract: This paper analyzes optimal social discount rates where people derive utility from relative consumption. We identify and compare three separate discount rates: the social rate (taking positional externalities into account), the private rate, and the conventional Ramsey rate. Two main findings resulted for the standard case with a positive growth rate: 1) the social discount rate exceeds the private discount rate if the degree of positionality increases with consumption, and 2) the social discount rate is smaller than the Ramsey rate if preferences are quasi-concave in own and reference consumption, and exhibit risk aversion with respect to reference consumption. Numerical calculations demonstrate that the latter difference may be substantial and economically important for such issues as global warming.

Abstract: Federal regulatory policy and the evaluation of regulations using benefit-cost analysis continue to be quite contentious. Advocates for more regulation claim that benefit-cost analysis loses information andimpedes our understanding of the real beneficial consequences of regulatory action. Against this backdrop, economists and advocates of economic analysis have sought to improve the quality and technical content of benefit-cost analysis. This paper examines key changes made by the 2003 guidelines in Circular A-4 for regulatory analysis issued by the U.S. Office of Management and Budget in an effort to strengthen such analysis. This paper discusses the motivation and basis for these changes—the treatment of discount rates and uncertainty and the cost-effectiveness analysis for rules affecting health and safety—and evaluates the EPA’s response to the A-4 changes in its analysis of environmental rules.

Abstract: This study measured the discount rates of a sample of 262 farm households in the Ethiopian highlands, using a time preference experiment with real payoffs. In general, the median discount ratewas very high—more than double the interest rate on the outstanding debt—and varied systematically with wealth and risk aversion. Although we do not have a good theory for explaining the linkagebetween rates-of-time preferences (RTPs) and risk aversion, our findings warn that these two aspects of household behavior reinforce each other and are easily confused. Our results have importantimplications for understanding households’ behavior. Because the RTPs were so high, what might seem like profitable investments from the outside might not seem so from the farmers’ perspectives.Furthermore, when future returns were uncertain, risk-averse decision makers favored projects with shorter payback periods and were less willing to invest in projects with long-term benefits. Formal capital market development, including lending and mortgage markets—currently non-existent in most of rural Ethiopia—may help reduce RTPs and cause more investments to be acceptable. The results also suggested the need for more research on the linkages between risk aversion and RTPs in low-income countries.

Abstract: The Economics of Climate Change: The Stern Review has had a major influence on the policy discussion on climate change. One reason is that the report has raised the estimated cost of unmitigated climate damages by an order of magnitude compared to most earlier estimates, leading to a call for strong and urgent action on climate change. Not surprisingly, severe criticism has been levied against the report by authors who think that these results hinge mainly on the use of a discount rate that is too low. Here we discuss the Ramsey rule for the discount rates and its implications for the economics of climate change. While we find no strong objections to the discounting assumptions adopted in the Stern Review, our main point is that the conclusions reached in the review can be justified on other grounds than by using a low discount rate. We argue that nonmarket damages from climate change are probably underestimated and that future scarcities that will be induced by the changing composition of the economy and climate change should lead to rising relative prices for certain goods and services, raising the estimated damage of climate change and counteracting the effect of discounting. We build our analysis on earlier research (Hoel and Sterner 2007) that has shown that the Ramsey discounting formula is somewhat modified in a two-sector economy with differential growth rates. Most importantly, such a model is characterized by changing relative prices, something that has major implications for a correct valuation of future climate damages. We introduce these results into a slightly modified version of the DICE model (Nordhaus 1994) and find that taking relative prices into account can have as large an effect on economically warranted abatement levels as can a low discount rate.

Abstract: Environmentalists are often upset at the effect of discounting costs of future environmentaldamage, e.g., due to climate change. An often-overlooked message is that we should discount costs butalso take into account the increase in the relative price of the ecosystem service endangered. The effect ofdiscounting would thus be counteracted, and if the rate of price rise of the item was fast enough, the effectmight even be reversed. The scarcity that leads to rising relative prices for the environmental good willalso have direct effects on the discount rate itself. The magnitude of these effects depends on properties ofthe economy’s technology and on social preferences. We develop a simple model of the economy thatillustrates how changes in crucial technology and preference parameters may affect both the discount rateand the rate of change of values of environmental goods. The combined effect of discounting and thechange of values of environmental goods is more likely to be low—or even negative—the lower thegrowth rate of environmental quality (or the larger its decline rate), and the lower the elasticity ofsubstitution between environmental quality and produced goods.