Balancing the Equation: How Discounting Rates Shape Perspectives on Climate Change Investments
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Decision makers face a balancing act as they weigh the potential benefits of sustainable investments against upfront costs
From rising seas to plunging crop yields, the multigenerational impacts of climate change present a dilemma to decision makers balancing the upfront costs of climate mitigation and adaptation against benefits that may only fully materialise years or even decades later.
Discount Rates and Climate Change Investment
In economics, the comparison between costs and benefits at different points in time is referred to as intertemporal choice. The general expectation is that a future benefit or cost is valued less than the same benefit or cost in the present—i.e., $1 today is preferred to $1 tomorrow. Such preference for the present is typically captured through discount rates, where a discount is assigned to future benefits or costs to express them in comparable “present-value” terms. A discount rate of zero, for example, implies equal weighting between $1 today and $1 tomorrow. As the discount rate increases, less value is assigned to the future relative to the present.
A decision maker, when weighing the initial outlay of a climate change investment against its expected future returns, must determine the discount rate that should be applied.
The Power of Compounding … in Reverse
Compound interest can grow an initial investment significantly over time. This is because interest is applied to not only the initial principal, but also any interest accumulated in all prior periods. The extent of compounding is highly sensitive to small changes in the interest rate, as this is successively applied over a long period of time.
A similar principle applies to discounting, but in reverse. A future benefit is heavily discounted over a long time frame, and the extent of that discounting is highly sensitive to small changes in the discount rate. As the chart below illustrates, at a 2 percent discount rate, a $1 million benefit discounted over a generation (thirty years) is just over $550,000 in present-value terms. Increasing that discount rate to 4 percent lowers the present value to just over $300,000.
This result has important implications for climate change investments. Consider a simplified, hypothetical example of a shoreline engineering project that is expected to generate a one-off $1 million benefit in thirty years’ time by preventing damage from a major flood. It is worthwhile investing $550,000 in this project at a 2 percent discount rate today, but only $300,000 at 4 percent. If there is uncertainty about whether the flood will occur, a higher discount rate would be used, which reduces the amount of investment that is justified today.
Social Discount Rate vs. Financial Discounting
Both policymakers and private investors use discount rates, but the principles underpinning those rates can differ. This can create tension between public and private-market efforts to address and account for climate risk.
Policymakers evaluating public projects use the social discount rate (SDR) to weigh outcomes over long time horizons. This process could involve certain philosophical and ethical judgments (also known as the “prescriptive” approach to SDR), such as in relation to intergenerational equity. For example, in the Stern Review, a landmark 2006 study commissioned by the UK government on the economics of climate change, multigenerational impacts were assessed on the basis that “we treat the welfare of future generations on a par with our own.” Certain base-case assumptions used in the Stern Review would give an SDR of 1.4 percent. The Stern Review advocated for immediate action on climate change, a conclusion driven, inter alia, by the weighing given to future generations in the SDR. Some economists criticised the policy conclusions in the Stern Review, noting that these were highly sensitive to its SDR assumptions.
SDRs can also be impacted by changes in political leadership. This can be illustrated by the different approaches US administrations have taken to assess the social cost of carbon (SCC), which estimates the cost to society of an additional metric ton of carbon emissions. The Biden administration used a 2.5 to 5 percent discount rate to estimate the global SCC, which gave average SCC estimates of $14 to $74 per metric ton as of 2020 (at the primary discount rate of 3 percent, around $49 per metric ton).[1] By contrast, the Trump administration used a 3 to 7 percent discount rate and focused on the SCC in the US only, resulting in a significantly lower estimate of $1 to $7 per metric ton as of 2020.[2] US federal agencies used these SCC estimates as inputs in conducting regulatory impact analyses, which could give starkly different policy conclusions.
In comparison, private investors use financial discount rates, which are driven by factors such as prevailing interest rates (which reflect the availability of financial liquidity) and investor risk appetite. Such financial discount rates are private in nature, as they reflect the rates of return those investors expect by investing in a project given its risk characteristics. Considerations that could be relevant to prescriptive SDRs, such as equity, do not feature in financial discount rates, and financial discount rates can thus diverge from SDRs. Where financial discount rates used to evaluate climate change investments are much higher than SDRs, there could be less than “socially optimum” levels of private investment.
Impact of Rising Interest Rates on Climate Investing
Post-2008, there has been an extended period of low interest rates and abundance of liquidity in advanced economies. This has brought down financial discount rates, which has tended to favor private climate-related investments, as investors were more willing to “trade” present-day costs for future benefits, such as investing in emerging carbon-capture technologies with uncertain payoffs.
2022 saw a rapid increase in interest rates, as central banks around the world responded to inflationary pressures. With increasing interest rates, private investors place greater emphasis on current costs, which can significantly impact the economic calculus of investment decisions.
For example, much of the overall cost associated with renewable power generation, such as wind or solar projects, arises at the initial capital outlay stage (in contrast to fossil fuel projects, whose costs are more spread out—this difference is driven by the lack of fuel costs for wind or solar generation). The levelised cost of electricity (LCOE), which measures the average net present cost of generation over a plant’s lifetime, is more sensitive to changes in interest rates for solar or wind than for coal or gas. All else equal, such changes in LCOE, especially if interest rates continue to increase, make renewable energy projects less economically viable.
Concluding Thoughts
The great economist John Maynard Keynes wrote: “Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.” The choice of discount rate and the underlying assumptions they reflect can greatly influence investment and policy decisions. Understanding this impact is particularly relevant in a high-interest-rate environment and in climate change investment given its long time horizons.
