An even Sterner Review, Introducing Relative Prices into the Discounting Debate

The Stern Review (2006) has come to symbolize something of a dividing line in the evolution of the common appreciation of the climate problem. It is fair to say that during the last decade there has been a gradual but uneven increase in the perceived gravity of anthropogenic climate change, both among scientists and, with some time lag, the general public.

However, save the United Nations Intergovernmental Panel on Climate Change (IPCC) assessments, the Stern Review is the first major, official report to give climate change a really prominent place among global problems. The political backing of the Stern Review in the UK is impressive. At its first presentation Sir Nicholas Stern was flanked by both Prime Minister Blair and Gordon Brown.

However, the Stern Review has been criticized on a number of accounts. The criticism has regarded both the manner in which the results are presented and the methodology underlying them, especially when it comes to the economics of discounting the future benefits and costs of climate change. For instance Nordhaus has a model DICE (Dynamic Integrated model of Climate and the Economy) which produces results suggesting climate change is not so serious and that relatively little abatement is needed. Nordhaus (2006) shows that DICE gives similar conclusions to those of the Stern Review if the rate of discounting is low suggesting that the only reason for the Stern results is the assumed discount rate which Nordhaus considers too low.

In this paper we show that results similar to those in the Stern Review can be obtained even without making the criticized assumptions concerning the discount rate. We do this by taking into account a neglected but important fact that relative price change is an inherent aspect of economic growth. As the rate of growth is uneven across the sectors of the economy - the composition of economic output will inevitably change over time. Output of mobile telephones may grow fast while glaciers and coral reefs decline and therefore relative prices will change.

We show that this has important implications for the efficient level of climate change mitigation. We present the results of some simulations using the same standard climate model,DICE in order to illustrate the impact that changes in relative prices can have on calculations of future climate-change damages. We conclude by arguing that greenhouse gas stabilization scenarios that are even more stringent than those discussed or suggested in the Stern Review could be justified.

There are many uncertainties when it comes to the climate. We are all used to hearing about the uncertainties related to cloud formation, feedback from methane in melting permafrost and ecosystem responses to rapid change, to mention just a few. Hence it may come as a surprise to some non-economists that the main source of uncertainty in estimates of the economic consequences of climate change is something else: the discount rate. In fact, much of the critique of the Stern Review has focused not on the climate science embodied in the report or its assessment of the costs and benefits of climate change mitigation, but on the low discount rate used in the analysis and how this drives the central results of the Review (see e.g., Dasgupta (2006), Nordhaus (2006), Weitzman (2006), Yohe,(2006))

The reason for the preoccupation with this seemingly trivial parameter is simple: since the impacts of climate change will mostly be felt in the future (because emissions of greenhouse gases are rising and because of the inertia of the climate system), the rate at which we discount the future will have a huge impact on what constitutes the efficient level of emissions reduction today. A simple example illustrates this point. The discounted value of one million dollars three hundred years hence is around fifty thousand $ today, using a discount rate of 1 percent, but if the discount rate were 5% it would be less than 50 cents! Note how this difference is strongly non-linear – in this example the value is changed by a factor of 100,000 when the discount rate is changed by a factor of 5.

Although a relatively simple concept in economics, the discount rate debate cuts to the core of many fundamental questions regarding global environmental change: how much weight should we put on the welfare of future versus current generations?, Will growth continue so that future generations are all richer than we are today? How important is the distribution of impacts ( i.e., how should we value costs that disproportionably fall upon the poor or the rich)? Consequently, when it comes to analysing climate change policy, the economics literature is far from a consensus on which value to choose for the discount rate. Nor is the academic debate on discounting that has followed the Stern Review a new one.

In section 2 we discuss the metric used by the Stern Review to present future costs. In section 3, we make some brief observations concerning the rate of discounting and its determinants. 2 Our aim here is to raise issues that we feel have been overlooked in the debate following the release of the Stern Review and that could have large implications for how seriously we regard global warming.

Section 4 introduces our main contribution: the effect of unbalanced growth on relative prices and the importance of these factors for the value of future climate damage. If, in the future, we have much more (of some) material goods but much less access to environmental goods and services, then the relative price of these environmental amenities will rise, and hence the value of climate damage will be higher. Section 5 concludes.

Co-author:

U. Martin Persson