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The Outlook for Climate Policies 223
If we deny our power and responsibility, we cannot hurt the planet itself. Indeed, Gaia has put herself through far more trouble than we can cause. Massive eruptions of flood basalts have at times pushed the global average temperature to extremes we will never see and, at other times, the planet may have turned itself into a huge snowball. Moreover, we are not the only creatures to have altered the climate of the Earth. Living things have caused climate change, and even occasional mass extinctions, ever since cyano-bacteria began spewing oxygen into the air billions of years ago.
However, we are the first species to recognize our effects on the climate. Our civilization evolved during the moderate, stable interglacial period of the last ten millennia, but natural forces by now should have nudged us back toward the start of another Ice Age. We may have brought that prospect to a halt. Our GHG emissions may have inadvertently helped us avoid the effects of a down-cycle in orbital factors and secured us interglacial warmth for at least another twenty millennia.
We are currently overdoing the warm spell. Nevertheless, our choices are not one-sided. We face a trade-off between current economic costs and future climate damage, and the risks are dificult to assess. If we fail to take adequate action, future generations will judge us harshly for the severity of the damages caused by our GHG emissions. But we could over-react and spend excessive resources now on avoiding outcomes that may be easier to prevent or adapt to in the future. So far, we have invested very little to reduce what are large risks of damage to the health, peace, and eco-nomic welfare of human society, and potential extinction of many species. Furthermore, overinvestment in mitigating climate change could be fairly quickly reversed, but if policy responses are inadequate, the momentum of natural amplifying feedbacks could be almost impossible to halt. We have surely not done enough to balance the risks in the outlook.
Although we will have to bear mitigation costs that we did not foresee when the industrial revolution began, we need not be overly gloomy about the prospects. After all, we have the resources and the knowledge to con-sciously manage the future climate of the Earth. Since its emergence more than 150,000 years ago, our species has suffered extremes of climate far more severe than what we face in the centuries just ahead. Now, however, we homo sapiens will endure only what we choose.
Appendix
Discount Rates in Climate Analysis
Discount rates are used to compare current and future costs. Confusion sometimes arises because of the failure to distinguish between a discount rate and a discount factor. To illustrate the difference, suppose you have a government savings bond that will be worth $1,000 next year. Because you need the money today, you sell the bond and only get $935. The discount factor is 935/1000 or 0.935. If you waited till next year, you would get the remaining $65. Your rate of return on holding the bond another year would thus be 65/935, which is 7%. That is the discount rate.
With a discount factor of 0.935, anything in the far-off future has a minus-cule present value. For instance, if you multiply 0.935 by itself a hundred times, the answer is only 0.001. The implication is that $1,000 of climate damages a hundred years from now is worth only $1 today. If a dollar spent on climate investments today would offset less than $1,000 of damages a century ahead, it would make more sense to invest in the stock market, assuming the market keeps earning the average 7% return it has in the past. A $1 investment in stocks at that rate of return would give your heirs $1,000 in a hundred years.
As the historical average real rate of return on the stock market, 7% represents the average rate of return on private sector investments in the economy. It is thus the opportunity cost of investing in a public project like climate mitigation. Indeed, the U.S. government uses that discount rate to evaluate public sector projects. However, some climate analysts argue for a lower discount rate because climate risks are different than the risks of a typical private sector investment (Cline, 1992). If climate uncertain-ties were uncorrelated with systematic risk in the stock market, you could lower overall risks by combining the two types of investments. That would justify a lower rate of return on climate mitigation than on the stock market. You couldn’t accept a return as low as 2%, however, which is the average
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short-term real interest rate, representing a risk-free return. A risk-free investment provides a guaranteed return in any circumstances and there-fore has a zero correlation with stock market risk. If the discount rate were as low as 2%, $1,000 of damages a hundred years from now would be worth $133 today.
Another reason for a lower discount rate is uncertainty about the rate itself. For instance, suppose you were uncertain whether to use a 7% rate or a 2% rate. If the chances were equal that either was right, you would have to average the associated discount factors to get the appropriate rate (because it’s the factors that are used to compute present values for the cost benefit analysis, not the rates per se). The average of .98 and .935 is .9575, equiva-lent to a discount rate of 4.25%, which is a little less than the average of the rates. The averaging of the discount factors over longer time periods implies an even lower effective discount rate.
The subject becomes even more complex because two different types of discount rates are used in climate studies: one for costs and another for social welfare. The discount rate for costs (and monetary benefits) is like an interest rate or the rate of return on the stock market, as discussed earlier. But evaluating policy alternatives based only on monetary costs and ben-efits is a shortcut for true welfare analysis. It works well enough for individ-ual projects that last only up to a few decades. However, for climate policies that affect the entire economy over longer time periods, the appropriate analysis requires measuring changes in overall welfare at each point in time and then discounting those effects to the present. The welfare discount rate (sometimes called the pure rate of time preference) is used for this purpose. It is not something observed, like the return on stocks. In theory, the cost discount rate should equal the welfare discount rate plus a sec-ond term related to risk aversion.1 If people didn’t care at all about risk, the two discount rates would be the same. It is possible to estimate the average risk aversion prevailing in society and, combining that estimate with the observed average return on stocks, the welfare discount rate could be found as a residual. Employing such methods, one recent study found a welfare discount rate of 1.5% (Nordhaus, 2007).
It is sometimes argued that we should ignore current social risk prefer-ences and instead use a very low welfare discount rate for ethical reasons. After all, shouldn’t we value the welfare of future generations as much as
1 More precisely, the second term is the relative risk aversion of the representative indi-vidual’s utility function multiplied by the growth rate of per capita consumption. For a recent review of the economics of discounting in climate studies, see Weitzman (2007).
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our own?2 From such sentiments, as well as the likelihood of heavier climate damages in poorer areas of the world, Stern (2006) called for a low welfare discount rate of 0.1%.
The choice of welfare discount rate is not just a fine point about iden-tifying one component of the observed return on stocks. It affects policy recommendations of how much should be spent today on mitigating future climate damage. It also has implications for future cost discount rates. We don’t know what the average return on investments will be far ahead in the future, but we expect it will decline as the world becomes more satu-rated with capital and the growth of consumption slows. A lower welfare discount rate implies that the return on capital will fall that much further in the decades to come.
2 Philosophical counterarguments can also be made. Because of continuing growth in per capita income, future generations almost surely will be wealthier than ours. This would be reflected in the measure of welfare at that time, but it would also weaken the case for using a lower welfare discount rate for future generations than we implicitly apply to ourselves later in our own lives, as indicated by observed social risk preferences.
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