Sunday, November 26, 2006

The Stern Report and the discounting issue: The Nordhaus Review

This recent review of the Stern Report is by William Nordhaus (Sterling Professor of Economics; Cowles Foundation, Yale University).

Hopefully, our own David Maddison will soon be providing his take on the Stern Report - by all accounts he has read the entire 700 pages. One issue that is sure to come up is that concentrated on by Nordhaus - "discounting".

The Stern Review on the Economics of Climate Change [PDF]

I will just pull out the main points - reading is recommended.

Some comments:

First, the Review is an impressive document, buttressed by more than a dozen background studies. There is little new science or economics here, but it provides many new syntheses of the extensive and rapidly growing literature. While not as balanced and ponderously reviewed as the reports of the Intergovernmental Panel on Climate Change (IPCC), it is much more current than the latest IPCC report, published in 2001.

Second, while I question some of the Review’s modeling and economic assumptions, its results are fundamentally correct in sign if not in size. The approach taken in the Review – selecting climate-change policies with an eye to balancing economic needs with environmental dangers – is solidly grounded in mainstream economic analysis.

Third, the Review should be viewed as a political document.

However, it is not an academic study. Like most government reports, the Review was published without an appraisal of methods and assumptions by independent outside experts. But even the analysis of HM Government needs peer review.

The fourth comment concerns the Review’s emphasis on the need for increasing the price of carbon emissions. The Review summarizes its discussion here as follows, “Creating a transparent and comparable carbon price signal around the world is an urgent challenge for international collective action.” In plain English, the Review argues that it is critical to have a harmonized carbon tax or similar regulatory device both to provide incentives to individual firms and households and to stimulate research and development in low-carbon technologies. Carbon prices must be raised to transmit the social costs of GHG emissions to the everyday decisions of
billions of firms and people. This simple yet inconvenient economic insight is virtually absent from most political discussions of climate change policy (including the marathon slide show by Al Gore in An Inconvenient Truth).

But these points are not the nub of the matter. Rather, and this is the final comment, the Review’s radical revision arises because of an extreme assumption about discounting. Discounting is a factor in climate-change policy – indeed in all investment decisions – which involves the relative weight of future and present payoffs. At first blush, this area would appear a technicality that should properly be left to abstruse treatises and graduate courses in economics. Unfortunately, it cannot be buried in a footnote, for discounting is the central to the radical revision. The Review proposes using a social discount rate that is essentially zero. Combined with other assumptions, this magnifies enormously impacts in the distant future and rationalizes deep cuts in emissions, and indeed in all consumption, today. If we were to substitute more conventional discount rates used in other global-warming analyses, by governments, by consumers, or by businesses, the Review’s
dramatic results would disappear, and we would come back to the climate policy ramp described above. The balance of this discussion focuses on this central issue.

The conclusion, after a further 20 pages describing and explaining the discounting problem, is as follows:
The radical revision of the economics of climate change proposed by the Review does not arise from any new economics, science, or modeling. Rather, it depends decisively on the assumption of a near-zero social discount rate. The Review’s unambiguous conclusions about the need for extreme immediate action will not survive the substitution of discounting assumptions that are consistent with today’s market place. So the central questions about global-warming policy – how much, how fast, and how costly – remain open. The Review informs but does not answer these fundamental questions.

Any "green" economist or activist should read this document to get an understanding of how the Stern report uses discount rates to arrive at its conclusions and the profound effect that the choice of discount rate has on these conclusions.

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