All over the world, governments are coming under increasing pressure to invest in projects whose benefits may not be reaped for decades and sometimes centuries. These critical areas for development span the gamut of climate change mitigation, environmental and biodiversity protection, nuclear decommissioning, enhancing infrastructure and coastal defences and long-term healthcare management, to name just a handful. Whether such projects can prove economically justifiable depends on an esoteric piece of policy wonkery called the “social discount rate” (SDR).
This SDR converts the future benefits and costs of public policy into their value today. It aims to compare social investments with different time horizons. SDRs vary widely among countries and international institutions but even the most minute difference can produce wildly divergent results.
Go deeper with GlobalData
Nonetheless, the Biden administration has recently proposed a dramatic change to the US’s SDR. It may have deep ramifications for climate policy everywhere – and, some believe, could help turn the tide in the world’s battle against climate change.
Generational value
SDRs help governments make decisions that balance the inevitable trade-offs in committing resources to people who are alive now and those to come. Saving the planet from climate change, for example, requires huge investment now, for the benefit of future generations. So this is money that cannot be spent on other problems today.
Most economic forecasts predict societies will get wealthier in future. As a result, a benefit today carries more value than the same benefit in future. Social discounting is the science of quantifying that effect, and for obvious reasons it lies at the heart of economic analysis of proposals for climate change mitigation. In this context, social discounting is inextricably linked to the ‘social cost of carbon’, the notion of assigning monetary value to damage done to the economy, environment and human welfare for every tonne of carbon we emit into the atmosphere.
“The discount rate may appear to be a very dry and technical variable, but, as this brings in compound interest, it really matters when you start doing long-term infrastructure and climate mitigation projects,” explains Mark Freeman, professor of finance at the University of York in the UK.
How well do you really know your competitors?
Access the most comprehensive Company Profiles on the market, powered by GlobalData. Save hours of research. Gain competitive edge.
Thank you!
Your download email will arrive shortly
Not ready to buy yet? Download a free sample
We are confident about the unique quality of our Company Profiles. However, we want you to make the most beneficial decision for your business, so we offer a free sample that you can download by submitting the below form
By GlobalDataFreeman compares this compound effect to your credit card. If your interest rate is 10% rather than 8% and you do not pay it off after a year, the slightly higher interest rate makes a bit of a difference, but not that much. However, the longer you go without paying the loan off, the more the interest compounds and the bigger the difference it makes.
“It is exactly the same thing here – small changes to the SDR over the many hundred years that carbon remains in the atmosphere result in huge differences in the perceived value of investing today in climate mitigation, and that is why these small percentage shifts really, really matter,” he says.
For climate policy to be adopted, it must therefore clear the cost-benefit threshold set by the SDR. The problem in the US at present is that the SDR is so high as to make most climate action proposals fail that test. Under the Trump administration, the US had two SDRs – one for consumption and one for investment – of 3% and 7%, respectively. Now the Biden administration is proposing to effectively scrap the 7% rate and decrease the 3% rate to 1.7%, which would be one of the world’s lowest SDRs.
Take electric vehicles, for instance. A regulation forcing people to trade in their gas-guzzler for a flashy new Tesla has clear costs and benefits – the cost of buying a new, more expensive car vs the benefit of a reduction in carbon emissions. In the US, federal agencies are required by law to do a cost-benefit analysis before any such regulation can take effect.
Keep up with Energy Monitor: Subscribe to our weekly newsletter“So, if carbon savings are valued at $190/tonne (t) [under] the new Biden proposal, which applies a low social discount rate, as opposed to $4/t under the Trump administration with a much higher social discount rate, it is going to be much easier to pass that type of legislation,” says Freeman.
In effect, the amount of CO₂ emitted is multiplied by the social cost of carbon. So, if a petrol car emits five tonnes of CO₂ a year, under the new proposals you would multiply that by $190, giving you roughly $1,000 per year of carbon benefits by switching to electric. If a car lasts ten years, that would be a benefit of $10,000 over its lifetime. So, if the cost of changing to electric is less than $10,000, the regulation can be implemented.
Under the 7% SDR of the Trump administration, that five tonnes of CO₂ a year would have been valued at just $20, given the $4 social cost of carbon. Over ten years, that would be a cost benefit of only $200 and, therefore, the cost of changing your car would have to be less than $200 for the regulation to be implemented.
In April, the US Environmental Protection Agency (EPA) announced new proposed federal vehicle emissions standards to accelerate the transition to clean vehicles between 2027 and 2055. These proposals would avoid nearly ten billion tonnes of CO₂ emissions, while saving thousands of dollars over the lives of vehicles meeting the standards and reducing the US’ reliance on approximately 20 billion barrels of oil imports, claimed the agency. An EPA spokesperson told Energy Monitor the agency had calculated the net benefits of the regulation for the period 2027–55 as $1.6trn using a 3% discount rate and $850bn using a 7% discount rate.
“The headline here is that [Biden’s] proposals will make it easier to justify government regulation on long-term projects, and this matters for green projects in particular,” says Freeman.
The Biden administration, citing Freeman’s research, issued two mandates to achieve this change. The first, Executive Order 13990, required federal agencies to review the cost that they attributed to greenhouse gas emissions in regulatory analysis – the social cost of carbon. Several Republican states challenged the use of the revised metric and a federal district court judge in Louisiana ruled that it was unlawful in February 2021. However, the Biden administration successfully appealed the ruling in a federal appeals court, and the US Supreme Court upheld the administration’s use of the social cost of carbon metric in May 2022.
Subsequently the EPA issued draft updates of the social cost of carbon, using a 2% SDR, in September last year.
Under the Obama administration, carbon emissions were priced at $43/t using a 3% discount rate. This dropped to $4/t under the Trump administration, which used a 7% discount rate, before Biden returned to the 3% rate and raised the cost of carbon emissions to $51/t as an interim measure. However, the proposed new EPA value, at $190 and which applies a 2% discount rate, would significantly enhance the cost-benefit analysis case for federal climate change mitigation policies.
To see how these figures interact, if the agency was to use a higher discount rate of 2.5%, thereby valuing the future less, the social cost of carbon would be $120; if it used a 1.5% discount rate, valuing the future more, the social cost of carbon would increase to $340.
In a second measure, Biden introduced the Modernizing Regulatory Review, which determines how general federal cost-benefit analysis is undertaken. This led to draft updates to Circulars A-4 (on regulatory analysis) and A-94 (for the analysis of spending federal grant money) in April this year, which stressed updates to discounting practices. This recommended an even lower discount rate than that applied by the EPA, at 1.7%.
In fact, part of the change was just an update of the existing formula, explains Noah Kaufman, a senior research scholar at Columbia University who previously served as a senior economist on the Biden administration’s Council of Economic Advisors. “It was basically an average looking back over 30 years of inflation-adjusted ten-year US Treasury bonds, and all they did was update that, which hadn’t been done for 20 years. And since the interest rate environment has just been so much lower over the past few decades, [the SDR] came down to 1.7%.”
SDRs: the magic number
SDRs differ all around the world – from as low as 1% in Germany to as high as 10% in Mexico. The average is typically somewhere between 3% and 5% in developed economies and above 5% in developing economies, according to Hilary Greaves, professor of philosophy at the University of Oxford, who has carried out research on discounting for public policy. “The 7% [of the Trump administration] is at the higher end of rates I have seen, except in developing countries. They have much higher rates of economic growth than developed nations because they are in that kind of explosive phase of development, and the faster your economic growth, the stronger the effect of expecting people to be richer in the future.”
However, a new study published in Nature Climate Change in May by environmental economists including Freeman and the University of Exeter’s Ben Groom found consensus between economists and philosophers over a 2% SDR. The authors surveyed 200 economists and philosophers and found a median recommended SDR of around 2%, which resulted in 1.4°C of global warming by the end of the century, in line with the Paris Agreement’s climate targets.
Read more from this author: Oliver GordonThe study was the first to attempt to build expert consensus on SDRs outside the field of economics, addressing ethical issues that fall outside most economists’ expertise. The findings therefore strengthen economists’ arguments for an SDR of 2% by underpinning it with ethical concerns for the welfare of future generations and the notion of ‘intergenerational equity’.
Although Greaves did not take part in the study, she says: “Insofar as the general thrust is 2% rather than 7%, philosophers generally, myself included, would think that is the right direction and a plausible magnitude. It is kind of hard to see how you could justify 7% without doing some form of discounting future well-being, as well as just stuff about people being richer in the future, and so it seems too high. Some would even argue that when you are considering very long timescales, the discount rate should actually be negative.”
A tough sell
Despite this rare interdisciplinary accord, the path for a 2% SDR to be widely adopted as climate policy is far from clear-cut. The primary concern would be attracting sufficient public support for the move: how do you convince people about regulation that may put them out of business or add a decimal place to their household bills?
“We have seen in countries like France, Canada and Australia that when you implement a carbon tax of $20/tonne (t), you get people on the streets,” says Freeman. “There is no sense that voters are going to vote for $190/t. If you think your car is emitting five tonnes a year, that is an extra $1,000 a year on your car alone. That is before you start thinking about heating your house or anything else. So, the question about whether this has democratic legitimacy is one that needs to be asked. If the full economic cost goes onto the general member of the public, this is going to be difficult to sell.”
There are some stark choices to be made. Freeman points out that although the World Health Organization predicts 250,000 people will die every year from climate change between 2030 and 2050, today half a million children die a year from diarrhoea – and every extra dollar you spend battling climate change is an extra dollar you are not spending combating that.
“The philosophers and the economists can stand there saying this will be the right thing to do, but then we need to actually make it happen – and that is really not trivial,” agrees Greaves.
For Kaufman’s part, he does not foresee this causing too much of a challenge for the US Government’s climate ambitions. He points out that, in the US, there is no direct mechanism by which a discount rate flows into policy details. Rather that is far more based on emissions goals, and the Democrats have set a target of achieving 50% emissions reductions by 2030. “We are going to try to put in place policies that get us on that pathway and towards a long-term net-zero pathway by mid-century,” he says.
Nonetheless, the changes to the SDR will lead to stringent carbon regulation in the US, and you may well see other countries following suit, posits Freeman. “One of the reasons the rates have come down in the US is because bond yields have come down,” he says. “And if we continue to see low rates of return in financial markets, that will certainly be a reason for governments to consider lowering their SDRs.”
