Low interest rates and social discount rates
In this paper Bauer and Rudebusch analyze how the long-run equilibrium interest rate affects the discount rate used to assess the future costs of climate change. In particular, the value of the social discount rate (SDR) is important for evaluating climate policy investments because the harm caused by carbon emissions persists for generations, and the effect of discounting such future costs gets magnified over time due to compounding. As a result, lower SDR supports spending more now to protect future generations from climate change damage.
The downward shift in SDRs over the past 30 years has important consequences for estimates of the economic costs of climate change. As Figure 1 shows, a drop in the discount rate from 2% to 1% greatly increases the present value of far-off damage—consistent with higher estimates of future climate costs and a higher [social cost of carbon] SCC. A straightforward way to quantify the effect of a lower discount rate is to compare the SCC calculated with the old 1990 and the current 2019 estimated discount rate term structures—applying each to the same assumed expected path of future damage from additional carbon emissions. The resulting levels of the estimated SCC vary depending on the specific models used to estimate discount rates and climate damage. However, the associated increases in the SCC from 1990 to 2019 are always substantial because the declines in r-star and the SDRs are robust across a wide range of models.
Climate Change Costs Rise as Interest Rates Fall
Authors: Michael D. Bauer, Glenn D. Rudebusch
From: University of Hamburg, Federal Reserve Bank of San Francisco
How to infer the appropriate social discount rate
In this paper Giglio et al. explore the information that private market discount rates contain about how to appropriately value investments in climate change abatement. They look at a traded asset with similar riskiness and horizons, namely real estate: first, real estate is a risky asset as its returns are positively correlated with consumption growth, and therefore with the marginal utility of consumption, and it performs badly during consumption disasters, financial crises, and wars. Second, real estate is exposed specifically to climate change risk, and this risk is reflected in house prices. These two characteristics of real estate are rendering this asset particularly interesting for the study of the valuation of investments to mitigate such risks.
The authors use a general equilibrium model with a representative agent and complete markets where climate change is a form of disaster risk. Their model incorporates a) feedback loops between the state of the economy and the time-varying probability of a climate disaster; and b) allow for economic growth to pick up temporarily after a disaster.
Since climate change is a form of disaster risk, investments in the mitigation of this risk are hedges: similar to insurance policies, they pay off primarily in bad states of the world, and are thus particularly valuable. This has a number of implications for the discount rates used to value their cash flows. The first implication is that the shape of the term structure of discount rates for investments to abate climate change is the opposite of what we estimate for the term structure of housing, a risky asset. In fact, the term structure for abatement investments should be upward sloping: hedging against effects of the disaster on short-term cash flows is more valuable than hedging the effects on long-term cash flows, since these long-term cash flows are affected less due to adaptation.
Importantly, however, this upward-sloping term structure does not imply that the level of discount rates for investments in climate change abatement is high at any horizon. In fact, it should be below the risk-free rate at all horizons, reflecting the investment’s hedge characteristics.
Climate Change and Long-Run Discount Rates: Evidence from Real Estate
Authors: Stefano Giglio, Matteo Maggiori, Krishna Rao, Johannes Stroebel, Andreas Weber
From: Yale University, Stanford University, Zillow, New York University
