Discount Rate Essay ⋆ Environment Essay Examples ⋆ EssayEmpire

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There is an ongoing discussion in environment-related fields about the practice of discounting in economic analysis. The need for discounting arises when economists seek to compare the costs and benefits of a project or policy that occurs over a number of years. Economists do not treat future costs and benefits the same as current ones, because the value of a dollar tomorrow is less than the value of a dollar today. This argument is theoretically related to two factors. First, this money can be invested, and interest earned, between now and the future. If the dollar is not received until the future, than such an investment opportunity is foregone. In practice, this foregone rate of return is often calculated at the prevailing interest rate (or the average productivity of capital) in a particular context. Second, economists argue for a positive rate of time preference for at least two reasons. First, the underlying level of impatience assumption suggests that people have a time-bound conception of their own self-interest that leads them to favor consumption in the present over that in the future. It generally has been assumed that poor households have a higher rate of time preference than wealthier ones as satisfying basic needs in the present is paramount. Second, a positive rate of time preference is suggested based on the belief that future generations will be better off than those in the present. According to this argument, current generations may reasonably weight a unit of consumption in the present more heavily than the same unit in the future, where it is assumed to be a proportionately smaller piece of an ever-expanding pie.

Projects in the private sector often rely on the opportunity costs of capital (or the interest rate) to establish a discount rate. It is disputed whether the discount rate for public sector projects should be based on the opportunity cost of capital or a social discount rate that is more closely associated with the rate of time preference. In the past, the World Bank has recommended that the standard opportunity cost of capital be used as the discount rate. Development economists typically have suggested a discount rate of 10 percent for projects in developing countries based on this opportunity cost criterion. Others argue that it is better to go with the social rate of time preference, as government and individuals are different than corporations in that they must consider a wider range of issues than just profit.

In practical terms, the discount rate enters project calculus when it is used to determine the net present value of all future benefits and costs. When all such costs and benefits are expressed in present terms, analysts may undertake a cost benefit analysis to determine if it is worthwhile undertaking a project. The formula for calculating net present value is (B minus C) divided by (1 plus r)year, where “B” equals benefits, “C” equals costs, “r” equals the discount rate, and “year” refers to the number of years into the future from the present.

The choice of an appropriate discount rate for the cost-benefit analysis of public sector projects is highly controversial. First, some assert that the use of a high discount rate, or any discount rate at all, leads to short-sighted assessment of costs and benefits, especially longer-term environmental costs and benefits. The higher the discount rate, the more significantly future costs and benefits will be progressively reduced each year in relation to current costs and benefits. Projects that affect environmental quality over the longer term, such as soil conservation efforts that will not yield results for ten years, do not appear to be remunerative investments when future benefits are highly discounted. Second, many have suggested that high discount rates have negative implications for inter-generational equity because this practice dissuades public entities from investing in projects that only generate significant benefits for future generations. Finally, there is an emerging body of scholarship that suggests poor people do not necessarily have higher rates of time preference than their wealthier counterparts. For example, recent empirical research in Zimbabwe found that poor subsistence farmers often demonstrate future bias in their decision making. The behavior of poor households under famine conditions in others parts of Africa also suggests a very low rate of time preference. The implications of this for discounting practice in the public sector are potentially significant. If one accepts that the rate of time preference may be a more appropriate determinant of discount rates for use in the cost-benefit analysis of development projects in the poorest countries, then it would seem reasonable to re-examine standard discount rates given that time preference rates for the poor may not be as high as previously thought.

Bibliography:

Hellweg, T.B. Hofstetter, and K. Hungerbuhler, “Discounting and the Environment-Should Current Impacts Be Weighted Differently than Impacts Harming Future Generations?” International Journal of Life Cycle Assessment (v8, 2003);
Hueting, “The Use of the Discount Rate in Cost-Benefit Analysis for Different Uses of Humid Tropical Forest Area,” Ecological Economics (v.3, 1991);
Lumley, “The Environment and the Ethics of Discounting: An Empirical Analysis,” Ecological Economics, (v.20, 1997);
W.G. Moseley, “African Evidence on the Relation of Poverty, Time Preference and the Environment,” Ecological Economics (v.38, 2001).