The Choice of Discount Rate for Climate Change Policy Evaluation

Abstract

Nearly all discussions about the appropriate consumption discount rate for climate-change policy evaluation assume that a single discount rate concept applies. We argue that two distinct concepts and associated rates apply. We distinguish a social-welfare-equivalent discount rate (rSW) appropriate for determining whether a given policy would augment social welfare (according to a postulated social welfare function) and a finance-equivalent discount rate (rF) suitable for determining whether the policy would offer a potential Pareto improvement. Distinguishing the two rates helps resolve arguments as to whether the choice of discount rate should be based on ethical considerations or empirical information (such as market interest rates), and about whether the discount rate should serve a prescriptive or descriptive role. Separating out the two rates also helps clarify disputes about the appropriate stringency of climate change policy. We find that the structure of leading numerical optimization models used for climate policy analysis may have helped contribute to the blurring of the differences between rSW and rF. In addition, we indicate that uncertainty about underlying ethical parameters or market conditions implies that both rSW and rF should decline as the time-horizon increases.