For the purposes of investors, interest rates, impatience and risk necessitate that future costs and benefits are converted into present value in order to make them comparable with each other. The discount rate is a rate used to convert future economic value into present economic value. This is realised through the mechanism known as discounting. For instance, if somebody offers to pay to you EUR 105 an year from now, the present value is EUR 100 if you would earn interest of EUR 5 on a deposit of EUR 100.
There are two main reasons for discounting. The first, called ‘pure time preference’, refers to the inclination of individuals to prefer 100 units of purchasing power today to 101, or 105, or even 110 next year, not because of price inflation (which is excluded from the reasoning) but because of the risk of becoming ill or dying and not being able to enjoy next year’s income. A famous critique of ‘pure time preference’ came from the Cambridge economist Frank Ramsey in 1928, who observed that discounting later enjoyments in comparison with earlier ones is ‘a practice which is ethically indefensible and arises merely from the weakness of the imagination’.
Nevertheless, economists continue to discount the future, as Ramsey himself did, because of the second reason. Economists assume that today’s investments and technical change will produce economic growth. Our descendants will be richer than we are. They will have three, four or even more cars per family. Therefore, the marginal utility or incremental satisfaction they will get from the third, fourth or fifth car will be lower and lower. Discounting is justified by the expectation of economic growth. However, Ramsey did not take environmental considerations and resource exhaustion into account.
We generally discount future amounts of money using constant discount rates, that is, discount factors of the form 1/(1+ r)t. This is called ‘exponential discounting’, and it implies that values in the distant future tend to have present values close to nothing. High discount rates imply giving low values to future damages, and thus, betting against the environment and future generations. A distinction can also be made between public or social discount rates and private discount rates. Both sectors use a positive discount rate (that is r > 0), but there is a difference in the fact that the social discount rate is lower than the private discount rate. This is because individuals (private sector) are mostly concerned with their own welfare in the very short term, and they are risk-averse, discounting future benefits heavily. On the other hand, the public sector (society as a whole) tends to have a longer-term perspective, entailing lower discount rates.
Considering nations or societies with time horizons in the thousands of years, discounting the future at all is highly questionable. This is one of the most heavily debated issues in ecological economics. Discount rates of even 1–2 percent per year shift the costs of environmental degradation to later generations, and reduce incentives for long-term environmentally favourable projects. From the environmental point of view, instead of exponential discounting when assessing future costs and benefits, a slowly declining rate of discount (reaching zero percent per year) could be used to give more value to the future. However, sometimes it is argued that a low discount rate (equivalent to a low rate of interest, therefore cheap loans from the banks) will promote investments that might be environmentally damaging. This means that there is need for a second filter to ensure their environmental sustainability (Padilla, 2002; Philibert, 2003).
Economic growth theory does not include in its accounting the costs of the loss of nature, or those of defensive expenditures by which we try to compensate for nature’s loss. If one tried to add up the genuine growth of the economy resulting from positive technical changes and investments (which nobody would deny), and the loss of exhaustible resources and environmental services caused by economic growth, the balance would be doubtful. (Furthermore, this would imply complete disregard for incommensurability of values.)
Discounting thus gives rise to an ‘optimist’s paradox’. The assumption of growth (measured by GDP) justifies our using more resources and polluting more now than we would otherwise do. Therefore, our descendants, who by assumption we anticipate will be better off than ourselves, might paradoxically be worse off – from the environmental point of view – than we are. Considerations of future well-being and intergenerational equity then requires the explicit incorporation of the widest range of economic, ecological, moral and ethical concerns, beyond the application of standard economics.
Ramsey, F. P. (1928). A mathematical theory of saving. The Economic Journal, 38(152), 543-559.
Padilla, E. (2002) Intergenerational equity and sustainability, Ecological Economics, 41 (1) 69-83.
Philibert, C. (2003) Discounting the future, International Society for Ecological Economics, Encyclopaedia [Accessed Nov 27 2012 from http://philibert.cedric.free.fr/Downloads/Discount2003.pdf]
For further reading:
Gollier, C. (2002) Time Horizon and the Discount Rate, Journal of Economic Theory, 107 (2) 463-73.
Norgaard, R. B., & Howarth, R. B. (1991). ‘Sustainability and discounting the future’. Ecological economics: the science and management of sustainability, 88-101.