Discounting A - intro

Reasons for discounting

Impatience / myopia

To earn interest / account for inflation

Human race

• All these reasons more applicable to individual rather than collective decisions

if future people richer than us then if we dont discount we enrich them further at our expense

Stern review on Climate change

Discount rate: ρ = 0.1%

• extinction risk is only ethical reason for discounting future consumption

Elasticity of MU of C: η = 1

• %Utility change depends on % =change in C

2 types of uncertainty

About rate of growth in consumption

Consumption discount rate ρ

Uncertainty and DR

Uncertainty can lead to a decreasing DR over time

• Risk aversion reduces DR

• UK % French Govt use decreasing DR over time

Uncertainty over consumption growth

Assume C growth rate (g) is idenpentantlly and identically normally distributed wtih mean 𝝁_g and variance 𝝈²_g

DR reduced by ½ η² 𝝈²_g

• effect likely small for developed nations

• Constant over time

DR may decline over time if g has unknown mean/variance + shocks to g positively correlated over time

Uncertainty about DR - NPV

Use Net present value (NPV) of £1000 received t years in future

• DR equally likely to be 1% or 7%

Uncertainty about DR - certainty equivalent

Uncertainty about DR effects

We make decisions on projects with long-term impacts today - this creates uncertainty about the DR

• Tomorrow we know what the DR is but today we dont

Over time, the certainty equivalent falls

• Uncertainty over DR resolved over time

• If DR +ve correlated then DR declines towards Lower bound over time

• If no correlation then DR remains constant

Time inconsistency and DR

Constant DR means time consistency

• once made decision (under certainty) you stick to it

Declining DR can lead to time inconsistency

• Certainty equivalent falls over time

• But is relative to the start value

But as new information arrives, decisions will be reconsidered

• Reduces worry about time inconsistency / DR

DR and CC

GHG E have benefits now & costs later

• higher DR = less mitigation now

Maximising discounted consumption is the most efficient outcome

• BUT doesnt take into account fair distribution for future generation

Efficient policy and compensation

Compensation used to have fair distribution

Efficient policy should have winners compensating losers

• Only if transfers feasible

If winners compensate losers then its a pareto improvement

• No one worse off than start and all benefit

If no transfers then policy decisions need to make sure on aggregate everyone benefits