# Discount rates, relative prices and climate economics

*economically efficient*level of abatement. Here's a simple example to illustrate the importance of choosing a particular rate of discount:

If we discount $100 a hundred years from now at a rate of 1 percent, we obtain a present value of around $37. However, if we feel slightly more impatient and raise the discount rate to 3 percent, then the present value falls to only $5!

__exponential__impact from the difference in discount rates, as well as the length of time that we are discounting. In other words, we're dealing with a distinctly non-linear process.The central message to take away is that – when it comes to estimating economic costs and benefits of the future – seemingly innocuous changes in your

*a priori*assumptions over the discount rate can lead to substantial differences in cumulative terms. (Use this calculator to see for yourself.)

*Stern Review*– from an economics perspective at least – were reserved for his choice of discount rate. By drawing on the famous Ramsey Equation[**], Stern used largely ethical arguments in deriving a final discount rate of 1.4%. This, his critics argued, was much too low in comparison with observed market rates, which are closer to 3-4%. Moreover, since Stern's major findings hang on a "low" discount rate, the same critics say that his central policy recommendation of "act fast, act now" does not hold. (Indeed, a belief in higher discount rates is what underpins a lot of economic rationalisation on the benefits of delayed action against climate change; e.g. focus on growing our economies as fast as possible now so that we will be in a better, wealthier position to deal with the effects of climate change in the future.)

*even in the presence of high discount rates*. Prior to this, opponents to early abatement paths such as those proposed by Stern have argued that such plans can only be sustained in the presence of what they perceive to be unacceptably/unrealistically low discount rates. And yet, we now see compelling economic reasons to follow an aggressive emissions path even when using high rates of interest.[***]

**THOUGHT FOR THE DAY:**The choice of discount rate is crucial to determining an "economically efficient" response to climate change. Unfortunately, there is widespread disagreement among economists as to what the correct discount rate is. However, by incorporating the impact of relative prices into our analysis, we can still

**conclude that it is better to act sooner, rather than later**... even if we assume a discount rate that is relatively high. And

*that*is a critical first step to reach agreement on.

*r = δ + η * g**r*), is equal to the sum of the pure rate of time preference (

*δ*) and the product of the elasticity of the marginal utility for money (

*η*) and the per capita growth rate of the economy (

*g*). To simplify, we interpret the first component of the equation,

*δ*, as the tendency to discount future utility simply because it is in the future. The second component,

*η * g*, implies that we value future consumption less than consumption today, because our wealth should increase over time as the result of economic growth. This latter notion rests on the assumption that a rich person gains less welfare than a poor person for a given quantity of money.

*always*have an impact on how aggressively we approach the issue of climate change. However, we are left with a central message that – regardless of differing opinions on what the discount rate should be – it is still in humanity’s best interest to decisively cut emissions sooner rather than later.

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