Who’s going to pay for climate change?

It’s widely accepted that the negative impacts of climate change are going to be felt for a very long time, and that in order to alleviate its effects on our children and grandchildren, we should be taking action now. However, determining the specific amount we should be spending on climate change now is difficult as planning horizons stretch far into the future and there is a huge degree of uncertainty involved.

So how do we measure costs that occur in the future?

A social discount rate based on the rate of social time preference is preferred by most economists when evaluating long term climate projects and policies. The social rate of time preference is the rate at which society would rather consume now than later. A high rate of time preference suggests that society is impatient and would rather spend more now than safeguard for the future. A low rate of time preference means that today’s society values its future consumption just as much as today’s, and would invest more to ensure future prosperity.

Think of it this way: If you’re a cautious person who believes there is a chance of something affecting your finances in the future, then you would be finding ways to invest or save your money today as a safety net for the future. Your rate of time preference is probably very low. But if you’re the type of person who enjoys living in the moment and worrying about the future when it comes, then your rate of time preference is very high. It is likely you would be spending a lot for yourself today and having little regard for your finances in the future.

The diagram above shows how much a cost of $100 50 years in the future would be valued today, according to different discount rates. For example, if we decided that future costs are just as important as today’s, then we would use a real discount rate of zero percent. At zero percent, a cost of $100 50 years in the future would still be valued at $100 today, and so we would invest $100 today to address climate change for the benefit of future people. However, if we were to use high discount rate of say ten percent, then we would value that $100 in 50 years at just 85 cents today. This means we would set aside just 85 cents of our current budget to address climate change (and spent the savings on whatever we want).

As you can see costs are very sensitive to changes in the discount rate. For this reason, it is essential that policymakers find an accurate discount rate.

So how do we determine what is the right discount rate?

The general consensus among economists is that when evaluating long-term climate policy, a discount rate based on the rate of social rate of time preference is most appropriate, as it optimises consumption between present and future generations.

The social time preference discount rate is found by:

ρ=δ+ηg

where δ is the rate of pure time preference, η is elasticity of marginal (social) utility and g is the growth rate of per capita consumption over time.

The Stern Review (2007) posits that using a high discount rate is immoral as it places a lower value on future generations for no reason at all, except for the fact that they are in the future. Much has been written about Millennial resentment towards Baby Boomers – in similar vein, if climate change is not the fault of future people, then why should they have to pay the price? Stern believes that present and future generations should be valued equally. For this reason, he advocates using a pure time preference rate of 0, and an overall social discount rate of 1.5 percent.

Nonetheless, Stern’s use of the zero pure time discount rate is controversial. Based on the premise that all generations should be valued equally, it demands that current generations should make huge sacrifices for future generations. Current generations could reason that instead of consuming resources today, these resources should alternatively be invested or kept for future use, where it has the potential to benefit a larger number of people. This then invites questions about entitlements – what are we, as present-day people, entitled to have and use, and what claims do future people have on our resources?

The only way to avoid the excessive demands of the zero pure time rate is by using a positive one which gives a slightly diminished weight to future generations, minimising their demands. Australia’s Garnaut Review (2008) recommends a pure time preference rate of 0.05 percent and a social discount rate between 1.35 percent and 2.65 percent, [2].

Conversely, a positive discount rate could result in excessive consumption of resources by current generations. Pigou (1932) argued that a positive pure time rate results in wasteful exploitation of nature’s resources, as current generations put a higher value on their own economic wellbeing than that of future people’s [3]. If the social discount rate is too high, then inefficiencies could occur. Current generations will overuse scarce resources and deny future generations the capacity or possibility to adapt to climate change.

But why is time even morally relevant? So what if future people will be affected more? Won’t they be richer, and so shouldn’t they be the ones to pay for it all?

Like our progressive tax system, it seems reasonable that because rich people have more, they should be paying more. On average, living standards have been steadily increasing around the world, and so it seems unfair that poor current generations will have to pay more than wealthier future generations, who will have a greater ability to pay for climate change policy. It also then follows that we could delay acting today, as technological innovation could mean that future humans could have better tools to combat the onset of climate change.

But how can we be sure future generations will be wealthier? Simon Caney makes the case that it is entirely possible that major war or economic crisis could occur, making future generations worse off [4]. Also, is economic wealth a metric of justice? Yes, future people might be richer, but they still had little responsibility for climate change, so why are they the ones who have to sacrifice the most for it?

Of course, all of these judgements are subjective, and the issues raised are big philosophical dilemmas that invite more questions than solutions. Despite this, one thing we can agree on this that the onset of climate change is inevitable and someone out there is going to have to deal with it sometime soon.

We hope you enjoyed this ESSA Article and our 2017 O-Week festivities! Are you a Monash university student with an interest in economics? Learn how you can join our publications team here: http://bit.ly/2mhxQjK

[1] Stern N (2007) The Economics of Climate Change: The Stern Review. Cambridge: Cambridge University Press.

[2] Garnaut, R. (2008) Garnaut Climate Change Review: Final Report. Cambridge: Cambridge University Press.

[3] Pigou, A.C. (1932) The Economics of Welfare. 4th ed. London: Macmillan. pp. 27-28.

[4] Caney, S. (2014). Climate change, intergenerational equity and the social discount rate. Politics, Philosophy & Economics, 13(4), pp.320-342.

Image: Pixar (2008)

Chart: Pham (2017)