Publication | ThinkSet
Balancing the Equation: How Discounting Rates Shape Perspectives on Climate Change Investments
Decision makers face a balancing act as they weigh the potential benefits of sustainable investments against upfront costs
From rising seas to plunging crop yields, the multigenerational impacts of climate change present a dilemma to decision makers balancing the upfront costs of climate mitigation and adaptation against benefits that may only fully materialise years or even decades later.
Discount Rates and Climate Change Investment
In economics, the comparison between costs and benefits at different points in time is referred to as intertemporal choice. The general expectation is that a future benefit or cost is valued less than the same benefit or cost in the present—i.e., $1 today is preferred to $1 tomorrow. Such preference for the present is typically captured through discount rates, where a discount is assigned to future benefits or costs to express them in comparable “present-value” terms. A discount rate of zero, for example, implies equal weighting between $1 today and $1 tomorrow. As the discount rate increases, less value is assigned to the future relative to the present.
A decision maker, when weighing the initial outlay of a climate change investment against its expected future returns, must determine the discount rate that should be applied.
The Power of Compounding … in Reverse
Compound interest can grow an initial investment significantly over time. This is because interest is applied to not only the initial principal, but also any interest accumulated in all prior periods. The extent of compounding is highly sensitive to small changes in the interest rate, as this is successively applied over a long period of time.
A similar principle applies to discounting, but in reverse. A future benefit is heavily discounted over a long time frame, and the extent of that discounting is highly sensitive to small changes in the discount rate. As the chart below illustrates, at a 2 percent discount rate, a $1 million benefit discounted over a generation (thirty years) is just over $550,000 in present-value terms. Increasing that discount rate to 4 percent lowers the present value to just over $300,000.
This result has important implications for climate change investments. Consider a simplified, hypothetical example of a shoreline engineering project that is expected to generate a one-off $1 million benefit in thirty years’ time by preventing damage from a major flood. It is worthwhile investing $550,000 in this project at a 2 percent discount rate today, but only $300,000 at 4 percent. If there is uncertainty about whether the flood will occur, a higher discount rate would be used, which reduces the amount of investment that is justified today.