Economics & discounting rates for climate change

Economics & discounting rates for climate change

Climate, the word is derived from the Greek word, which depicts the inclination of earth’s rays, which is a reminder again of the importance of warmth than cold, in fact it is far more efficient to heat up than extract heat, or most economic systems are far better attuned to heat additions than heat extractions as the progress of the last three hundred years have been facilitated by heating systems that produced the much needed energy to propel modern systems forward.

The earth had been mostly very hot over its 4.5 billion years of existence but there were severe spells of low temperature epochs in the latter stages, but undoubtedly the current period of permanent settlements over the last 10,000 years is one of relatively low temperatures, barring the last century where there has been significant human activity that has led to temperature increase; the non-linearity of results notwithstanding but taking Ockham’s Razor, as a principle, (when multiple competing hypotheses are equal in other respects, choose the hypothesis that introduces the fewest assumption), CO2 as a heat trapping gas and its abundance created by emissions is a good enough reason to go after, if we want to limit temperature increase. But Methane and NO2 or SO2 are also to be dealt with but have other consequences as well.

Climate, the word is derived from the Greek word, which depicts the inclination of earth’s rays, which is a reminder again of the importance of warmth than cold, in fact it is far more efficient to heat up than extract heat, or most economic systems are far better attuned to heat additions than heat extractions as the progress of the last three hundred years have been facilitated by heating systems that produced the much needed energy to propel modern systems forward. The economics of heating or energy never precluded the absorption of CO2 as an externality, a cost that must be endured and therefore paid for by the consumers; had it been the norm, the current use of fossil fuels would have seen natural moderations and renewable energy sources would have by this time proliferated at a frenetic pace.

The importance of the externalities, the costs that are to be borne by the society, for example the cost of CO2 released to the environment when an item is produced for consumption, only remained in the economics footnotes and only in the last two decades some meaningful treatment has been meted out. But think of it as Bill Gates points out in his book, “How to Avoid a Climate Disaster”, clean versions of fossil fuels for cargo ships are at $5.5 -$9.05 per gallon against their fossil fuel versions which are at $1.29 per gallon, making them hugely uneconomical, whereas if the cost of externalities are included this difference would considerably reduce. It is same as investing in climate change actions for the future, none of which would at the moment give benefits to the environment. Therefore it is as good as saying that corporations are entering into pledges for the future which would need investments and the environmental benefits will only be visible and enjoyed by generations in the future, for which the current stakeholders would have to bear the costs.

To put it differently what part of consumption now needs to be foregone, in order that the future consumption can be maintained? Or how much profits would have to be foregone now for future benefits? But a unit of consumption now or profits is not the same as a unit of consumption or profits in the future. So we enter the realm of time-discounting rates to fix this problem.

But how do you impose the social cost of externalities and what would be the economic impact for the current generations while they altruistically take the brunt of “climate change” impact now so that the future generations enjoy large parts of the benefit. This is what the economists calculate through the time-discounting rates. These are not mere market rates of return on investment, but that they ought instead to be derived from economic forecasts and society’s conception of distributive justice concerning the allocation of goods and services across personal identities, time, and events. Inter-generational transfers and the incentives for savings over consumption needs to be weighed against a non-linear and highly unpredictable future impact on livelihood and environment forced by climate change. No doubt this is an arduous task in itself.

But there are potentially two distinct camps in which the economists are camped into, Nordhaus, who supported a milder action on climate change and who got the Economics Nobel in 2018 and the Stern camp, after the Stern Report (2006) that specified far more stricter actions on climate change now, believing that aggressive abatement is worthwhile even though the future is much richer, because the potential massive damages warrant the costs. When you take milder scheme of things, where current consumption can continue, you are in effect proposing a different discounting rates, like the high 4 to 7 per cent, while anything between 1 to 2 per cent is a low enough discounting rate for the very drastic measures now.

The real implications of these two discounting rates is the following. If the current generation is too impatient to enjoy the benefit now against that in the future, the consumption discount rate needs to be higher. Also an unit of consumption now against the cost of that in the future is higher, as the opportunity cost of capital itself would propound and that is not going down but only moving up. So in effect Nordhaus is proposing a milder version of actions, that of a much higher discounting rate, so that current consumption now is valued and not therefore foregone that easily.

Stern camp however is believing that foregoing consumption now is the more important thing to do so a much higher foregoing of consumption is necessary for a dramatic result in the future, which will avert the crisis. But it essentially means that corporations and consumers would have to bear the brunt of these actions in the current times.

Think of a steeper slope of climate actions now versus a less steep slope in the future? It means that an industry would have to invest now and that would mean it would draw away capital from the alternate use of it. Further to maintain the same level of profit, it would need to factor the price increases necessary to compensate for the rising costs, this must be paid for by the consumers.

This would also mean that an entire industry in a specific space must act as an industry body, otherwise it will never work, some could get away being the free-rider, thus removing all incentives for actions. On the other hand the government or the regulatory body must factor in the loss of income that could ensue if economic activities get impacted due to higher prices or lower profits that impact government revenues.

Thus net zero pledge is a serious debate on the current versus the future benefits and time discounting rates. Those corporations who take a drastic view of things are actually discounting at a lower rate, they are willing to forego current profits for a better future and essentially this is making the corporation stronger for the future, than currently what it could be without these actions.

Footnote:

ABOUT THE AUTHOR:

Procyon Mukherjee is an ex-Chief Procurement Officer at LafargeHolcim India.

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