Putting a price tag on climate change

Recent economic research suggests that households may be more willing to bear the costs of climate change mitigation than previously thought.

How much are you willing to pay to offset the cost of climate change? How great would the future benefits need to be before you are willing to bear that cost? Recent research provides some insight into the value we place on our future.

One of the more contentious issues surrounding climate change (admittedly one of many) is how best to evaluate near-term costs against benefits that may arise in the distant future. For many, global warming is a moral issue: we have a moral obligation to provide a healthy and viable environment for future generations. For others, it is simply another form of investment: does the financial return exceed the cost?

Regardless of whether you consider it a moral imperative, the reality is that most governments across the world have treated climate change as a financial issue. Complicating matters, however, is that the benefits of global warming mitigation accrue many decades and centuries from now.

What discount rate is appropriate for investments with such long-term benefits?

Recent research by Stefano Giglio, Matteo Maggiori and Johannes Stroebel, Very Long-Run Discount Rates (and summarised at Voxeu), provides some insight into how much “individuals value cash flows that arise hundreds of years from now and will accrue to future generations”. They believe that their research has important implications regarding the costs and benefits associated with mitigating the damage of climate change.

The literature provides a mixed view. Lord Nicholas Stern, asked by former British prime minister Tony Blair to look into the economics of climate change, called for immediate action to reduce future environmental damage based on the assumption of a very low discount rate. His argument was that people have an ethical impetus to provide a healthy and sustainable future.

By comparison, William Nordhaus, an economics professor at Yale, suggested a discount rate of around 4 per cent in 2008 paper. Stern had placed an annual discount rate of just 0.1 per cent on future cash flows. Nordhaus view is more consistent with the type of discount rate applied to other investment proposals.

The research by Giglio et al helps to formalise an approach to discounting cash flows in the very distant future. They utilise residential housing data from the United Kingdom and Singapore, where property ownership takes the form of either very long-term leaseholds or freeholds.

Leaseholds are “temporary, pre-paid and tradable ownership contracts with maturities ranging from 99 to 999 years”. By comparison, freeholds are “perpetual ownership contracts”. The price discount for very long-term leases compared with freeholds for similar properties provides insight into the discount rate applied by people trading these assets.

Their empirical analysis is based on property sales in the UK from 2004 to 2013 and in Singapore from 1995 to 2013.  

The graph below presents estimates from the United Kingdom for flats. They find that leaseholds with 80 – 99 years remaining are valued around 15 per cent less than otherwise identical freeholds; leaseholds with maturity of 100 – 124 years is discounted by around 10 per cent compared with similar freeholds. As the lease period extends further into the future the leasehold price converges with the freehold price.

Graph for Putting a price tag on climate change

These estimates can be used to back out the implied discount rate for cash flows that occur in the very distant future. They find that the annual discount rate is around 2.6 per cent and broadly similar between both the United Kingdom and Singapore. This discount rate is much higher than the assumption used by Lord Stern but noticeably lower than discount rates that rely on the medium-term return to capital.

I should note that this represents an average discount rate over the sample used by the researchers. For those who place a high priority on the environment, their personal discount rate may converge with that used by Lord Stern.

But others may balk at the very prospect of large investments now and uncertain benefits later. The latter case is particularly relevant for older Australians and our policymakers since most of the benefits will occur well after they have passed away.

It’s also worth asking whether it is reasonable to assume a similar discount rate for climate change investment as it is for property. In practice, it would depend on the respective risk-return profile for each type of investment. However, in the absence of any alternative source of long-term data, it is surely a superior methodology than simply using short-term discount rates and applying them in perpetuity.

The findings by Giglio et al obviously don’t say anything about the cost of action against climate change. There remains no general consensus in that regard. But these discount rates, applied to recent research by Lord Stern, suggest that households would be reluctant to bear the cost of climate change mitigation that he has suggested (Why economic models of climate change need better science, June 17).Their estimates also suggest a greater willingness to tackle climate change than is commonly assumed by the current literature into the economics of climate change.