Resolving the Paradoxes of Discounting in Environmental Decisions

• Author: Joseph H. Guth
• Position: Legal Director of the Science & Environmental Health Network
• Pages: 05

Joseph H. Guth, J.D., Ph.D., is Legal Director of the Science & Environmental Health Network (www.sehn.org). I gratefully acknowledge the helpful and supportive comments of Carolyn Raffensperger, Burns Weston, and Tracy Bach, as well as the capable research assistance and comments of Katherine Moll. An earlier version of this article was prepared as Joseph H. Guth, Background Paper, Resolving the Paradoxes of Discounting in Recalibrating the Law of Humans with the Laws of Nature: Climate Change, Human Rights, and Intergenerational Justice (Climate Legacy Initiative 2009), available at http://www.vermont law.edu/Documents/012108-cliPolicyPaper.pdf.

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I Introduction

Carbon emissions, radioactive waste, and species extinctions affect not just the present but also the future, sometimes the distant future. As our impact on the Earth mounts, the specter of the future that we are creating is looming larger, becoming more insistent. The advent of global warming, especially, impresses upon us that environmental degradation is implicating not only our own welfare but also that of future generations. As we consider taking stronger steps to protect the environment, topics that may seem arcane, such as "cost-benefit analysis" and "discounting," are being drawn into the public discourse. ¹ Discounting, it turns out, holds the key to understanding why our economic and legal systems are having such a difficult time controlling mounting, long-term environmental degradation.

Our prevailing framework for balancing economic and environmental interests when they conflict is to compare the costs of individual activities with their benefits. This decision-making structure starts with the presumption that economic activity is socially beneficial, that is, produces a Page 96 net benefit for the society.² In keeping with this presumption, environmental laws can restrain damage done by the market economy, but they generally place the burden of proof on the government to demonstrate that the benefits of a regulation outweigh its costs.³ Within this decision-making framework, a particular analytical problem arises whenever we obtain the benefits at one time while bearing the costs at another. When this happens, we must compare the value of costs and benefits that accrue in the future, sometimes the distant future, with the value of those that accrue in the present. This analytical comparison is handled through a technique known as "discounting."

Discounting is a mathematical technique for determining the value to us today, the "present value," of costs or benefits that occur in the future. The technique alters future values by a specified percentage every year, which is known as the "discount rate." For example, employing a discount rate of 3 percent or 7 percent would reduce the value of future costs and benefits by 3 percent or 7 percent per year, respectively, to calculate their present value. Employing higher discount rates causes future values to decrease more rapidly, which results in attributing lower present values to future costs and benefits. A discount rate of zero would attribute the same value to future as to present costs and benefits. A negative discount rate would attribute a higher present value to future costs and benefits than to present ones.⁴

The outcome of cost-benefit-driven decisions is highly dependent on how discounting is used. studies show that for many regulations the choice of discounting method can have a profound effect on whether regulations are judged cost-effective.⁵ In one striking example, a 2006 report from the British Treasury, The Stern Review on the Economics of Climate Change, found that global warming would impose large costs on the future, warranting Page 97 substantial and immediate preventive action.⁶ This conclusion differs from that of other economists who have found that global warming justifies only modest action now.⁷ The difference is driven by Sir Stern's choice of a very low positive discount rate rather than the higher rate used by other economists. ⁸ Thus, under our current environmental decision-making structure, whether we should take strong immediate action on the critical issue of global warming turns on the seemingly arcane choice of a discount rate.

While some debate exists over the importance of future generations, most discounting analysts agree that we should hold them equal to our own.⁹ One might think that we could determine how to use a simple mathematical device like discounting to fulfill this obligation to future generations. But as we will see, no particular method always furthers that objective. Each particular method of using discounting or even not using it can lead to inconsistencies and perverse results. Unfortunately, the answer to the question of whether a particular discount rate benefits the future or the present is: it depends.

Discounting does not provide a coherent approach to protecting the interests of future generations. This Article will show that the reason originates with flaws in the assumptions underlying the cost-benefit decision-making framework itself. These outdated underlying assumptions are inconsistent with the modern realities of environmental degradation. If we are to protect the ecological integrity of the biosphere for future generations, we will have to adopt new assumptions that accord with our new ecological reality. Then we must use these new assumptions to build a new structure for making environmental decisions that will make not just discounting but cost-benefit analysis itself all but irrelevant.

II The "Paradoxes" of Discounting

Many economists hold that cost-benefit analysis should apply some positive discount rate to all costs and benefits, reflecting their conclusion that we should place less value on benefits received in the future than those received in the present and, symmetrically, should prefer to incur costs in the Page 98 future rather than today. ¹⁰ In a 2001 survey, 2160 economists most commonly chose a discount rate of 2 percent (with a median choice of 3 percent and a mean of 4 percent) for calculating the present value of the costs of long-term environmental problems.¹¹

Perhaps reflecting this widespread view among economists, the U.S. government is strongly committed to using cost-benefit analysis and positive discount rates in developing environmental regulations. Presidential Executive Order No. 12,866, signed by President Clinton, commands all federal agencies to propose or adopt regulations, including environmental regulations, only if they can show that the benefits justify the costs (unless a particular statute requires otherwise). ¹² The White House Office of Management and Budget (OMB) actively enforces Executive Order No. 12,866, and it has issued detailed guidance on the conduct of cost-benefit analysis, ¹³ including the use of positive discount rates. ¹⁴ The OMB recommends that agencies perform two separate analyses of their regulations, one employing a 3 percent discount rate and one employing a 7 percent discount rate. The OMB recites the 7 percent rate as the average before-tax rate of return to private capital in the U.S. economy, and contends that it approximates the opportunity cost of capital and is therefore the appropriate discount rate whenever a regulation displaces the use of capital by the Page 99 private sector.¹⁵ OMB recites the 3 percent rate as the historical real rate of return on long-term government debt, and believes that it approximates the social preference for present consumption over future consumption and is therefore the appropriate discount rate whenever a regulation primarily affects private consumption (e.g., by affecting the price of consumer products).¹⁶ In some circumstances, the OMB believes a higher rate of 10 percent,¹⁷ or sometimes a rate below 3 percent,¹⁸ could be appropriate and recommends regulatory agencies consider these as well.

The U.S. Environmental Protection Agency (EPA) has issued similar guidance on the use of positive discount rates.¹⁹ In a recent example, the EPA calculated the costs and benefits of a Clean Air Act regulation using both 3 percent and 7 percent discount rates.²⁰ Analysts who have broadly examined agency compliance with the OMB guidelines on discounting find that agencies now frequently employ discounting, though in varying ways.²¹

Those who support the use of positive discount rates offer several reasons for concluding that future costs and benefits are worth less than present ones. ²² One is the empirical evidence that people have what is called a "positive time preference," meaning that people actually prefer to receive benefits now rather than receive the same benefits in the future.²³ Another is that if the economy continues to grow as it has for most of U.S. history, consumption of particular benefits now will be of greater marginal utility than in the future when we are richer and our consumption is greater.²⁴ The idea is that any particular cost or benefit will constitute a smaller portion of society's total wealth, and thus be of less marginal value, in the future than in the present.

The main reason, however, is grounded in the opportunity cost associated with spending resources now rather than later.²⁵ The logic is that if we spend Page 100 money to obtain particular benefits today, we will have forgone the opportunity to invest the money, let it grow in value, and then have more real wealth in the future with which to purchase benefits. In effect, present benefits are thought to cost more than future benefits because when we spend resources now to obtain them, we lose the opportunity to invest those resources and...