The central reason that the Stern Review’s recommendations have not come to fruition is that The Review’s critics contend that Stern improperly handles future generations. The question of how to treat future outcomes relative to present ones has long been debated by philosophers and economists alike. We shall return to the debate, but first let’s look at the consumption discount rate, δ, which is currently the tool used by economists to handle the question of futurity. The discount rate is the rate at which society is willing to trade present benefits for future ones. It may be useful to think of the discount rate as similar to the interest rate given by banks. Like with banks, future consumption is less valuable than present consumption. A dollar today is more valuable than a dollar in the future. The discount rate formula is:
δ = ρ + gη
where ρ is the social rate of time preference, g is the projected growth rate of average consumption, and η is the elasticity of the social weight attributed to a change in consumption.
So what does it all mean?
Let’s start with g, which is simply the projected growth of the economy. For example, if we project the economy to grow at 1% annually, then we put 0.01 in for g.
Next we’ll turn to η, which accounts for the fact that as consumption grows, the marginal value of consumption decreases. It is derived from the economic law of diminishing returns. For instance, a poor person with a low level of consumption will value a $1 increase in income much more than will a rich person with a high level of consumption. Another example, if hungry, we enjoy our first piece of pizza much more than say the tenth piece. The parameter η is relatively uncontroversial; there is a consensus with it being between one and three.
We are now ready to return to the exciting debate of whether the future should be discounted simply because it is the future. This matter is contained in ρ, the social rate of time preference. On the one side we have the position of most philosophers who argue that present generations have the moral obligation to protect the interests of future generations. They maintain that a value of zero for ρ would ensure equality across generations as it prevents the present generation from ignoring the long-term environmental consequences of present-day activities. For instance, positive values of ρ can lead to almost entirely devaluing disastrous environment impacts that occur over 50 years into the future. Nicholas Stern endorses this view as his Stern Review uses a value of 0 for ρ.
Most economists support the other side of the debate. Their view is that investments made in the economy today will increase the wealth of future generations thus making them more able to respond to any environmental issues. The view relies on the optimism that technology, wealth, and human ingenuity will be able to solve any future environmental problem. For example, there is a large group of climate change skeptics who believe that the problem can be solved in the future by merely sucking the greenhouse gases from the atmosphere-like a vacuum (crazy right).
Stern uses a low discount rate, one that many economists disagree with. Moreover, they oppose his conclusions and recommendations because of the discount rate disagreement. It is no wonder then that policy makers cannot come to a consensus on a plan when economists cannot settle their own discounting debate.
All for now,
AC
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