Long-Term Discounting Frameworks
By Simon Levin:
"Discounting is in part a reflection of uncertainty about the future. But what is the right discount rate to use? It would be difficult enough were we contemplating just our own futures, or even those of our children; where concern for others and the future structure of societies is involved, there is no obvious right answer. Indeed disagreement about the proper discount rate to use is what divides those who accept from those who reject the findings of Britain’s Stern Commission on climate change.
But dealing with discounting in the context of intergenerational transfers is doable. Countries such as Sweden, Denmark, Germany, and Poland have employed relatively long-term perspectives, on the order of several decades, in developing national strategies for sustainable development. Finland has developed a “Programme for Sustainable Development” that incorporates intergenerational indicators that must be monitored; biodiversity preservation is one target of the scheme. This is, at least, a beginning.
With a number of colleagues (including this author), the economist and Nobel Laureate Kenneth Arrow has developed a framework that addresses sustainability by considering an unlimited future, emphasizing ethical considerations that take account of the estimated utilities of future generations—that is, what the future holds for them as measured by things that contribute to their total welfare. The framework’s sustainability criterion requires social welfare to not decrease over time. Of course, the discount rate remains key, as does how utility is measured; most crucially, though, the framework explicitly weights the needs of future generations. By this measure, the performance of individual nations can be assessed, and changes that enhance sustainability can be prescribed. Beyond being a contribution to economic theory, Arrow and his colleagues’ approach has received wide attention and could be a basis for policy initiatives going forward.
The central issues in achieving sustainability are thus ones of temporal allocation, of prosociality toward others (that is, concern for the welfare of others), of cooperation, and of the social norms that sustain cooperative behavior. We live in a global commons, in which the collective consequences of individual actions have externalities and social costs, and these are not adequately addressed through conventional market mechanisms. These problems are magnified as the scale of organization is increased, where individual nations are the units of decision making. Garrett Hardin, in addressing the “tragedy of the commons,” argued that the solution lay in “mutual coercion, mutually agreed upon.” And indeed, such self-enforcing mutual agreements can work effectively in small communities to achieve sustainability.14 But how do we go beyond small communities to achieve cooperation at the global level?
When nations are the agents in the search for international cooperation, with all the attendant asymmetries, it remains difficult if not impossible to get agreements on issues like climate change and biodiversity loss. Some new dimensions are needed.
Ultimately, we need new institutions and enforceable agreements that not only work today, but also are robust in a changing environment. Despite the unique challenges, and occasional glitches, international agreements have been effective for more than 60 years in combating nuclear proliferation and the use of nuclear weapons, although the robustness of the Nuclear Non-Proliferation Treaty is facing severe challenge today. Thus we have examples of successes, but even in these successes we must recognize risks and the need to be adaptive.
One step in this direction is to create a modular structure to meet global challenges, in which parts can be changed as needed without leading to systemic collapse.25 For management, modularity means creating firebreaks to impede the contagious spread of disturbance: for example, many diseases spread rapidly within risk groups, like drug users or particular schools, but can then be contained because of the reduced probability of transmission among groups. Indeed, the first line of defense in dealing with an emerging epidemic, from foot-and-mouth to SARS, is to slow down travel, whether cattle or humans, to reduce the rate of spread. The loss of modularity is widely believed to have been a major factor in the catastrophic financial collapse of 2008—the system was too overconnected.26 Any successful scheme must be adaptive: one can design schemes to deal with today’s threats, but flexibility and adaptability are essential for adjusting to the unforeseen challenges ahead.
Accounting for future generations is perhaps an even greater challenge, because they do not have negotiators at the bargaining table. We in the present must care about future generations, decide how to discount and how to evaluate their utility functions, and develop a framework for protecting their interests. The “Brundtland Report”2 recommends a basis for commitment; what we need now is a way to quantify what the limits on present consumption must be to achieve that goal.
Arrow and colleagues10,27 provide a first proposal in that direction, allowing for corrections for technological growth, population growth, and other confounding factors, though significant ethical and technical challenges remain. Their key argument is that “sustainable development requires sustained well-being,” mandating that “each generation … bequeath to its successor at least as large a productive base, relative to its population, as it had itself inherited.”27 This is the essence of sustainability and the only pathway to the future." (http://www.thesolutionsjournal.com/node/1144)
- Weitzman, ML. Gamma discounting. American Economic Review 91, 260–271 (2001).
- Dasgupta, P. Discounting climate change. Review of Environmental Economics and Policy 37, 141-169. (2008).
- Pearce, D, Groom, B, Hepburn, C & Koundouri, P. Valuing the Future. World Economic 4(2), 121–141 (2003).
- Portney, PR & Weyant, JP, eds. Discounting and Intergenerational Equity (Resources for the Future, Washington, DC, 1999).
- Barrett, S. Why Cooperate: The Incentive to Supply Global Public Goods (Oxford University Press, Oxford, UK, 2007).
- May, RM, Levin, SA & Sugihara, G. Complex systems: ecology for bankers. Nature [online] 451(7181), 893–895. doi:10.1038/451893a.
- Arrow, KJ et al. Consumption, investment, and future well-being: reply to Daly et al. Conservation Biology [online] 21(5), 1363–1365. doi:10.1111/J.1523-1739.2007-00783.X.