Traditional cost-benefit analysis tends to undervalue long-term investments, especially in natural capital. Discount rates often overlook impacts beyond 20 years. To rectify this, we need policies that prioritize long-term sustainability.
The utilization of economic tools in decision-making for developmental projects is pivotal, given that economic analysis aids decision-makers in validating investments and ensuring their economic viability.
Nonetheless, cost-benefit analysis, a tool often employed in this process, is a social construct, shaped by our prevailing values, including our preference for the present over the future, capital over human resources, and infrastructure rich in steel and cement over the environment.
The inherent challenge with cost-benefit analysis lies in its bias towards the present, which impedes investment in long-term projects incorporating natural capital. The common practice in cost-benefit analysis of discounting future benefits to their present value exhibits our inclination towards immediate gratification. Yet, this method ought to reflect the reality that investments in natural capital take years to mature and yield benefits that incrementally increase over time.
The notion of "discount rates" is integral here. Economists utilize the discount rate in cost-benefit analysis to represent future costs and benefits in present-day terms, facilitating policymakers' judgment on the viability of a project. A higher discount rate devalues the future stream of net benefits and costs compared to a lower one, signifying that we undervalue benefits the further they stretch into the future. This becomes problematic when contemplating long-term effects such as climate change.
Traditional cost-benefit analysis is limited in its scope. Historically developed in the late 1960s for short to medium-term physical capital investments, like roads, dams, buildings, and bridges, the method operates under the assumption of an operating life less than 25 years, with benefits materializing soon after construction.
In contrast, projects focused on forestry, pollution remediation, and climate adaptation underscore that natural capital requires years to develop and yields benefits far into the future. The ecological and ecosystem values of an afforested or rehabilitated area may take decades or even centuries to fully restore. The benefits derived from these natural capital investments progressively increase over time, contrasting with the rapid returns of man-made capital investments.
Considering the escalating socio-environmental, cultural, and climate-related challenges, we now require much lengthier time horizons, extending beyond 25 years and potentially up to 100 years. The application of constant positive discount rates overlooks effects beyond 25 years. Higher discount rates result in less consideration of future benefits today and amplify the opportunity cost.
Such high discount rates undermine the long-term benefits of climate mitigation and adaptation investments, suggesting that today's investments will disproportionately burden future generations with climate challenges.
The common practice in cost-benefit analysis of discounting future benefits to their present value exhibits our inclination towards immediate gratification.
This imbalance between the needs of current and future generations has sparked considerable debate about incorporating inter-generational discounting. Investment decisions with substantial initial costs and larger future benefits become preferable when discount rates approach zero. As the benefits of investments to counter potential impacts of climate change will accrue far into the future, employing the lowest possible discount rate becomes less discriminative.
The concept of declining discount rates has garnered traction in recent years. Also known as hyperbolic discounting, this approach assigns equivalent value to medium and distant futures, with the discount rate decreasing the longer the time horizon. This practice is justified by the anticipation that individuals' discount rates will decline over time. As early as 1998, Weitzman proposed using varying rates depending on the lifespan of the project.
Various countries have adopted diverse strategies to address this challenge. The United Kingdom has officially endorsed declining discount rates, transitioning from a rate of 3.5% in year 10 to a rate of 2.5% in year 70, and ultimately to 1% in year 300. Experts in France and Canada also implement declining discount rate schedules.
The recent US Environmental Protection Agency report adopted a 2% discount rate, marginally lower than the 3% rate used by the Obama administration.
Research on social discount rates in Australia, Canada, Germany, and the United Kingdom reveals considerable differences in the suitable schedule of discount rates to be applied. For instance, Canada utilizes a steeper declining discount rate schedule than other countries, reflecting the higher volatility in historical Canadian interest rates. Consequently, each country ought to devise a customized declining discount rate (DDR) schedule.
In the event of climate change and sea-level rise prompting catastrophic alterations necessitating immediate intervention, negative discount rates may be required to render adaptation investments financially viable, as these investments yield benefits over time.
Rarely applied in investment decision-making, negative, minuscule, or diminishing discount rates need to gain prominence if we aim to invest in development projects mindful of climate change adaptation with future benefits. Although these investments may appear costly presently, they will yield considerable returns in the future, beneficial to the generations that will inhabit the world we shape today.
For governments, development organizations, and banks, the implications are:
- The chosen discount rate significantly influences climate decision-making as well as policy and investment decisions.
- In projects involving extended time horizons, even minute adjustments in the discount rate become pivotal.
- Lower, zero, or even negative discount rates necessitate the current generation to invest more heavily in development projects today, indicating an expense for a better future.
Governments, development organizations, and banks should reassess their values and priorities, giving greater weight to the long-term benefits of sustainable investments and ecosystem restoration over immediate, albeit short-lived gains.
These sustainable investments may appear less immediately bankable, but their impact will be substantial and long-lasting.