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Deep Dive Into Interest Rates Raises Value of Environmental Action


The case for taking apparently very costly action to contrast trends that negatively impact our environment is overwhelmingly larger than widely imagined, according to remarkable new research conducted by a multinational team of economists, mathematicians and physicists.

The case for taking apparently very costly action to contrast trends that negatively impact our environment is overwhelmingly larger than widely imagined, according to remarkable new research conducted by a multinational team of economists, mathematicians and physicists.

 

REUTERS/Bob Strong

Analysts doing cost-benefit analysis of taking action against global warming ultimately must choose a discount rate to compare the relative price burden we would face today with the benefits we’d receive in the distant future.

The discount rate, which is widely used in banking, finance and pension accounting, refers to the implicit cost of and presumed average returns to money over a specific time frame. For example, if you think you can earn 10% on your saving ahead of retirement, you can set aside less now and still retire comfortably than if you were able to earn only 2.5% on offer from the U.S. Treasury bonds, the risk-free asset per excellence. Analysis of global climate change naturally involves extremely long time frames, which multiply the effect of the discount rate assumed.

Nicholas Stern’s landmark review on the economics of climate change, published in 2006, settled on a discount rate of 1.4%. Mathematically, that means that the future – defined as 100 years hence – is worth 25% of today. It offers a benchmark to asset the merits of action plans to contrast climate change.

The Stern Review suggested that substantial resources be devoted immediately, now and perpetually, to avoid dark troubles ahead. Other economists argued that Stern’s discount rate was pessimistically low, noting that financial markets in most countries signal higher discount rates. Different estimates have dramatic effect. For example, using a 4% discount rate in a 100-year environmental model suggest that the future has a present value of only 2%. Raise the discount rate to 6% and the future’s present value shrinks to only 0.3%.

With higher interest rates, “costly action today would appear to be foolish,” note the authors of “Discounting the Distant Future,” the new paper published by the Cowles Foundation for Research in Economists at Yale University.

As is well known, many public and corporate pension funds like to postulate high discount rates – meaning they assume the assets they manage will grow in value at a high rate – as that lowers the amount of money they actually have to take in from contributors in order to deliver on promises decades into the future.

So what is the right discount rate?

The paper’s authors, who come from Yale, Oxford University, the Santa Fe Institute and the University of Barcelona’s physics department, perused more than a century’s worth of bond yields and inflation for a slew of countries – for Italy their data set goes back to 1861 – and conclude that for stable countries, including the U.S. and U.K., the historical mean real interest rate is around 3%. A similar figure emerges from Wall Street’s forward-looking models, which influence the way banks and financiers fund their activities, most of which are short term.

But saving the planet is a practical task, and practically reality-based analysis must be aware of the often sharp fluctuations in the interest rate over time. That consideration is particularly germane today, as central banks have pushed official rates to zero in a bid to revive economic activity and in response to price trends hovering around an inflection point leading to deflation.

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