Monthly Archives: September 2012

224 – Torturing ourselves over discounting

Economists’ practice of discounting benefits from the distant future to make them comparable to current costs is fraught with disagreement and controversy. But for projects that are not very big and very long-term, there is often no need for us to torture ourselves over how and how much to discount.

Discounting became a topic of broad discussion in the wake of public debates about studies of the economics of climate change mitigation. Most of the predicted benefits from actions we take now to attempt to mitigate climate change are predicted to occur in the distant future – e.g. 100 to 200 years hence. Discounting is used to convert those future benefits into present values, so that they can be compared with present costs, in order to judge whether and which action is worth taking.

It makes a huge difference to the result how much and how you discount. The problem is that there is wide disagreement amongst economists on how much and how to do it. Positions adopted by different economists include that:

  • We should use the rate of growth of the economy as the discount rate.
  • We should use a probability distribution of discount rates to allow for uncertainty about future growth rates (Weitzman 1998). The result of this approach is equivalent to using a discount rate that declines over time.
  • We should reduce the discount rate on equity grounds so that people in the future are not disadvantaged. (That’s the position taken in the Stern Review.)
  • We should not use discounting at all because discounting and Benefit: Cost Analysis are the wrong way to think about the problem.

The fact that views about discounting are so diverse reflects that we actually don’t have a sound theory for discounting in the long term that deals with all of the complexities of the issue. As Steve Schilizzi and I point out in our 2006 book on discounting, a sound theory for discounting in the very long term would have to deal simultaneously with three issues: efficiency (maximising the size of the pie, irrespective of who wins and loses), equity (who wins and loses) and uncertainty (which, when thinking about the very long term, is extreme).

I provide an intuitive illustration of the difficulties and dilemmas in Pannell Discussion 34.

For now, my view is that, if we are going to use discounting for benefits and costs in the very long term, the most defensible approach is that of Weitzman. He at least allows us to combine efficiency and uncertainty (about the discount rate – not about other things). I don’t think anybody has any valid idea how to adjust discount rates to account for equity. Certainly not Stern. His adjustments, supposedly for equity, made his results more inequitable, in my view.

Maybe some bright spark will sort it out eventually. Or maybe the problem is just intractable and will never be resolved. Maybe we’ll eventually converge on the view that discounting is the wrong way to think about the problem – that’s where my colleague Steve Schilizzi has moved to recently.

Given all the options and disagreements, discounting is a topic that environmental economists like to torture themselves and each other with. We write many papers and books and reviews about the options and the difficulties, often sounding confident, but in reality not getting particularly close to a genuine resolution.

An unfortunate consequence of this focus on the difficulties of long-term discounting is that it starts to create doubts about the use of discounting in the short term. In fact, discounting benefits and costs in the short term (within a generation – say 30 years) is reasonably unproblematic, in my view, and should be undertaken in all project assessments. The things that make long-term discounting so problematic – extreme uncertainty, inter-generational equity – are much less serious in the short term.

Of course there is uncertainty about most projects or investments, even in the short term. But it’s usually fairly safe to assume that the range of potential outcomes is within a probability distribution that we can imagine in the present. In the very long term, it’s not safe to make that assumption; the world is likely to change in fundamental but currently unimagined ways.

Equity is a significant factor that needs to be considered in the short term as well as the long term, but in the short term it is possible to offset undesirable equity outcomes using other mechanisms, such as financial transfers. In the short term, adjusting discount rates is clearly not the way to pursue equity. For large, long-term problems like climate change, my feeling is that efficiency and equity are intertwined and inseparable (although it still isn’t clear that adjusting interest rates is a sensible way to advance equity).

So for projects that are not really big and long-term, my view is that standard text-book discounting methods are completely appropriate. The discount rate should be the opportunity cost of capital (often the interest rate on borrowings). This applies to all sorts of projects, including environmental and social projects that generate non-financial benefits.

Even if the project you are assessing would generate benefits beyond 30 years, sometimes it’s reasonable just to ignore those later benefits. This isn’t as bad as it might sound, as present values are small relative to future values beyond 30 years (e.g. if a constant discount rate of 5% is used, future values get reduced to 23% after 30 years, 9% after 50 years).

Another potential justification for ignoring benefits beyond a few decades is that one’s confidence that those benefits would actually be maintained decreases for the more distant future.

Thirdly, it may be that we are only interested in generating the benefits for a few decades and not beyond.

Fourthly, for many projects, including or excluding those later benefits would not alter the decision on whether to fund the project. This could be explored using sensitivity analysis with different discount rates or methods. If the result is not affected by inclusion or exclusion of later benefits, we can conveniently side-step the tricky issues around long-term discounting.

Of course, there are cases where the long-term benefits really matter to us and would make a difference to funding decisions. In these cases, follow  Weitzman.

 Further reading

Pannell, D.J. and Schilizzi, S. (eds) (2006). Economics and the Future: Time and Discounting in Private and Public Decision Making, Edward Elgar, Cheltenham, UK and Northampton, MA, USA.

Pannell, D.J. (1997). Sensitivity analysis of normative economic models: Theoretical framework and practical strategies. Agricultural Economics 16(2): 139-152. Full paper hereIDEAS page for this paper

Weitzman, M.L., (1998). Why the far-distant future should be discounted at its lowest possible rate, Journal of Environmental Economics and Management, 36(3), 201-208. IDEAS page for this paper

 

223 – Leadership

Strong, inspiring, visionary leadership can have a huge influence on people, pulling them together and changing their direction. But is it the only thing that can achieve that? And is it necessarily a good thing?

I participated in a very interesting discussion about leadership this week. One of the participants was a radio astronomer who had been involved in the successful bid for the Square Kilometre Array project in Western Australia – a massive undertaking. She said that a key factor in getting radio astronomers to overcome their differences and unify behind the bid was a small number of outstanding leaders in the discipline. Most people in the discussion were agricultural scientists, and they were discussing whether agricultural scientists could also get a large, visionary national project funded in Australia and what could be learnt from the SKA experience.

One of agriculturalists argued that leadership is not just important for change, it is essential — that you generally don’t see big changes occur across a large group of people where the change propagates from the bottom up. That was quite thought provoking, and at the time I couldn’t think of a counter example.

Later on I identified a couple of economics-related examples where major changes regularly happen without any leadership at all. One is our adoption of new technologies. Think of Steve Jobs and Apple. No doubt, Jobs was the archetype of a strong, inspiring, visionary leader within Apple, and had a huge influence on the company and its staff. But outside the company, it was different. We didn’t all buy ipods, iphones, ipads and ikettles because we were inspired and led by Steve Jobs. (Well, maybe a few did, but mostly not.) We did it because these are great products, and perhaps because Apple has a cool reputation. Millions of us changed our behaviour towards purchase of Apple products, and that in turn further influenced our behaviour in myriad ways, but there was no unifying leader that directly influenced us to change in these ways.

Another example is the behaviour of people in markets. Markets can have a major influence on the behaviour of people by the simple mechanism of pricing. If there is a shortage of a product (say, wheat), the price is bid up. This encourages more producers to produce wheat, and it encourages consumers of wheat to cut back on their wheat consumption, so the shortage is addressed. The wonder of the market is that there is no leadership required for this to happen. It occurs efficiently and reliably through the aggregation of many individual decisions.

Could these examples provide a different way (other than by leadership) to bring agricultural scientists together, to push them in a particular new direction? Perhaps it would be possible to think about the incentives that scientists face and influence their behaviour by modifying those incentives. That might mean that we wouldn’t need inspiring leadership, but I think we would still require strong leadership with a clear vision to arrange for the new incentives to be put in place. So for this particular type of change, my feeling is that the comment was right; leadership is crucial.

My other thought about this, though, is that we should be careful what we wish for. The directions that leaders take us in are not necessarily good ones. In the agricultural context, I’d point to the history of salinity in Australia. The profile of salinity as a problem for agriculture (as well as for water, biodiversity and infrastructure) grew through the 1980s and 1990s, culminating in the creation of the National Action Plan for Salinity and Water Quality in 2000. A small number of high-profile scientist leaders/advocates were pivotal in the creation of this $1.4 billion program. It was the one of the biggest environmental programs in Australia’s history, and its creation must have seemed like a huge success for those who had been pushing for it. But in fact the program was fundamentally misconceived. It would have needed to be designed and delivered in entirely different ways to have any chance of meeting its objectives. In the wake of its obvious failure, resources for salinity management and salinity research have almost completely dried up. So the apparent major success of getting a huge national program established was actually the beginning of the end of the issue as a national priority.

Further reading

Hermalin, B.E. (1998). Toward an Economic Theory of Leadership: Leading by Example, American Economic Review 88(5), 1188-1206. IDEAS page for this paper

Pannell, D.J. and Roberts, A.M. (2010). The National Action Plan for Salinity and Water Quality: A retrospective assessment, Australian Journal of Agricultural and Resource Economics 54(4): 437-456. Journal web site hereIDEAS page for this paper