our financial model can better illustrate long-term value
- Written by Dorje C. Brody, Professor of Mathematics, University of Surrey
When deciding whether to invest in environmental projects, it’s important to consider the economic value of any long-term benefits.
Whether climate solutions[1] (such as offshore wind power or solar farms) are recognised as valuable or worthless depends very much on which economic model[2] is used to evaluate it.
If the present value of the benefit (calculated by using a widely accepted financial model called “exponential discounting”) is too small compared to the cost, it may seem to damage the economy too much.
As a mathematician researching in finance, my study shows how it is possible to use another financial model called “social discounting” to value the long-term benefits far into the future. My colleague and I have demonstrated that a perfectly consistent valuation method can be established[3] using social discounting.
Exponential discounting is commonly used to calculate the present value of a future benefit. Banks use this all the time to calculate the value of products linked to interest rates[4]. Exponential discounting tells us how much to put in an account now to reach that future value – it incorporates how, when interests accumulated overnight are instantly put into the account, those interests will accumulate additional interests.
Social discounting is another way of calculating the present value of future, long-term benefits such as the prevention of drought, forest fire, or the submersion of coastal cities.
A recent University of Exeter report titled Recalibrating Climate Risk[5] highlights a range of shortcomings in how traditional economic models are applied to climate issues[6].
While it makes sense to use exponential discounting if the future beneficiary of the decision made today is the same person who is making the decision, that isn’t always the case when they are different.
The benefits of long-term social projects for sustainable energy or climate change may only arise in 100 years. By using an exponential discounting model, a large benefit occurring in the distant future will be assigned an unfairly low value right now. This won’t be enough to justify the costs involved in funding the project, so the project might not get off the ground.
Given that future generations have no say on choices made by society today, it seems unfair to heavily discount their future benefits. Nevertheless, there is a strong argument, most notably advocated by the climate economist and Nobel laureate William Nordhaus[7], that investment in climate projects should be treated like any other investment; subject to the usual exponential discounting.
The Nordhaus argument is widely used to evaluate climate policies around the world. For example, a UK thinktank[8] called the Global Warming Policy Foundation has used it to warn the government against investing in safeguarding future generations. Fossil fuel companies employ versions of the Nordhaus argument to deter public investment[9] in climate policy and focus on the short-term benefits of an economy based on fossil fuel extraction.
Leaving aside morale and ethical debates on the use of exponential discounting, a little-known principle[11] in finance shows that the exponential rate of discounting cannot decline over a long time horizon when benefits of climate policies are delivered.
One consequence is that the benefit of long-term social projects to tackle climate change is inevitably heavily discounted in the exponential model. This makes the investment seem less attractive, making it difficult for lawmakers to pass climate bills.
An alternative assessment follows from using social discounting, where the discounting is considerably milder so that the present value of the benefit of a climate policy far in the future may be as significant as the amount of investment required for implementing the policy, making the investment a worthwhile proposition.
In spite of its morale attraction, in the academic literature it was thought for a long time[12] that it is not possible to evaluate future benefits in a consistent way using a social discounting. Without evaluating future benefits in a reliable, consistent way makes it difficult to argue the economic case for a climate investment. But my research shows that it is possible.
There are no economic or financial reasons to circumvent the use of social discounting on the basis of consistency. So it’s time to move on from the old-school economic arguments favoured by the fossil fuel industry and other climate sceptics.
References
- ^ climate solutions (theconversation.com)
- ^ economic model (theconversation.com)
- ^ can be established (doi.org)
- ^ interest rates (www.risk.net)
- ^ Recalibrating Climate Risk (greenfuturessolutions.com)
- ^ climate issues (theconversation.com)
- ^ Nobel laureate William Nordhaus (www.nobelprize.org)
- ^ a UK thinktank (www.thegwpf.org)
- ^ deter public investment (doi.org)
- ^ vectorfusionart/Shutterstock (www.shutterstock.com)
- ^ a little-known principle (www.jstor.org)
- ^ it was thought for a long time (doi.org)
