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IPE Views: Discount rates and setting a price for nature

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The guardians of discounting can use their special insights to serve their fellow human beings or to bamboozle them, Joseph Mariathasan warns

Modern finance is based around the idea of discount rates. Indeed, there is a whole intellectual framework built around the idea of adding risk premia to risk-free government bond yields when assessing investment opportunities.

Yet the framework is actually very shaky. Nick Goddard of Long Finance published a primer in September on the uses and abuses of discount rates. As an former physicist, he wondered whether the idea was just an unavoidably complex piece of financial wizardry that provided invaluable insights into financial decision-making. Or, alternatively, was it an unnecessarily complex obfuscation, useful mainly for conferring an aura of technical rigour to whatever the banker’s gut-feeling was telling him?

His conclusion was that the idea is a mixture of both.

Much decision making is predicated on using results from the analysis of discounted cashflows, and these results are highly dependent on the discount rate used. How does one assess a roll of the dice when one of the outcomes is the end of civilisation as we know it?

This issue was raised in the 2006 Stern Review on climate change, and it is also true when assessing how to value the effects of losing species and environmental degradation that can lead to the loss of complete ecosystems. Economics does not appear to have a robust framework for assessing multi-generational issues.

In these cases, individuals are foregoing consumption not for their own future benefit but for the benefit of their grandchildren and future generations – for posterity – for which the rejoinder has sometimes been ‘what has posterity ever done for me?’

The Stern Review estimated that a 1% per annum cost would be needed to protect the world economy from a loss of up to 20% of global consumption. In the case of biodiversity and ecosystem losses, the size of such premiums depends on a number of factors that include the current state of the ecosystem in question; the threshold state at which it fails to deliver ecosystem services; its targeted conservation state; and our best estimate of uncertainties.

But there are no market values for any of these measures. Moreover, whilst ethics do not usually play a part in economic theory, a fundamental question arises in any discussion of valuations: what should be an appropriate discount rate to use in the valuation of future benefits?

The choice is between giving up current income for the benefit of future generations, or the opposite – gaining benefits now at the expense of future generations. One of the two reasons economists would justify the use of discounting is the inclination of individuals to prefer 100 units of purchasing power today to 101, or 105, or even 110 next year, not because of price inflation (which is excluded from the reasoning) but because of the risk of becoming ill or dying and not being able to enjoy next year’s income.

But this should not apply to a nation or human society with a time horizon in the thousands or hundreds of thousands of years. Indeed, as the report argues: “Modern economists favour discounting not because of ‘pure time preference’ but the decreasing marginal utility of consumption as growth takes place. The assumption of growth, measured by GDP, justifies our using more resources and polluting more now than we would otherwise do. Therefore, our descendants, who, by assumption, are supposed to be better off than ourselves, perhaps will be paradoxically worse off from the environmental point of view than we are.”

Most of the valuation studies examined in the report used discount rates in the 3-5% range or higher. As it highlights, a 4% discount rate means we value a natural service to our own grandchildren (50 years hence) at one-seventh the utility we derive from it, a difficult ethical standpoint to defend.

Clearly, economic growth and the conversion of natural ecosystems to agricultural production will continue. However, it is essential to ensure such development take proper account of the real value of natural ecosystems, which is central to economic and environmental management.

The problem is, man-made goods and services are growing in quantity while the services of nature are not. This argues for a discount rate that is negative, on the basis that future generations will be poorer in environmental terms than those living today. Moreover, the real costs of the loss of biodiversity and ecosystems should also include the value of the options inherent in the existence of ecosystems.

Whilst this may be difficult to measure, the value placed on conserving resources for possible uses in the future is significant. This is not only because our knowledge of the importance of ecosystem services is expected to improve over time but more significantly because part of the losses of biodiversity and the services it underpins are irreversible.

“Economic growth might produce virtual Jurassic Theme Parks for children and adults; it will never resurrect the tiger if and when it goes” says a report entitled ‘The Economics of Ecosystems and Biodiversity’, commissioned by the G8 plus five environment ministers in March 2007.

Grappling with discount rates may ultimately lead to the conclusion reached by Goddard in his own report: “Like priests, guardians of the mystical truths of discounting can use the special insights with which they have been blessed either to serve their fellow human beings or to bamboozle the rest of humanity into serving them.”

Joseph Mariathasan is contributing editor at IPE

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