Grandma and Grandpa are sitting alone in their living room in Dubuque, Iowa in February. It is -15° Fahrenheit (-26°C) and they haven’t been truly comfortable in two months. They want a Club Med vacation – get down to a warm, sunny place for a few weeks – but they are living on Social Security payments.
Their quandary is solved, however, when they realize they can raid their six-year old granddaughter’s college savings account with about $12,000 in it. Great!
The couple books a month-long trip to a sun-drenched, all-included resort vacation – returning just about the time the first glimmers of spring start to appear in the Midwest. Their granddaughter doesn’t care, or even know, about the damage done to her prospects.
While this scenario might seem nuts from a morality standpoint, it is, in fact, perfectly sensible from the standpoint of financial theory.
The fundamental concept of finance is the “Time Value of Money” (TVM), explained simply as “a dollar today is worth more than a dollar tomorrow.” This concept, which has been historically attested to since around 500 CE, implicitly values the life and comfort of people in the present day more than that of those in future periods.
Obviously, the TVM concept starts to break down in extreme cases – Club-Med grandparents and climate change are two perfect examples.
This series of two articles is about applying TVM to the topic climate change and the mechanism for doing that – the “discount rate.” It might seem like an arcane, academic topic, but I can say without hyperbole that it is a question that is key to whether human civilization thrives or collapses.
What’s the Right Discount Rate?
The accepted method for converting the value of a future dollar into the present is by using what is known as a “discount rate.” You know about discount rates through the concept of a bank account’s interest rate or the yield on a bond investment. A company wants to borrow $100 in a bond issuance and promises to pay back $105 at the end of the year. In this case, the discount rate is 5%, meaning that you need 5% more future dollars to equal a given quantity of present dollars.
One recipient of the 2018 (fake) Nobel Prize in Economics, Yale University’s William Nordhaus, believes that when considering climate change, we should use a discount rate of 3%. While this rate may not seem very high, looking at a time horizon of 100 years, the standard equation for figuring future values says that it would take about $2,009 in 2119 dollars to equate to just $100 today ($100 * e^(100 years x 3%) = $2,008.55).
The logical conclusion of this finding as it relates to climate change is that it is better to save money today by not embarking on expensive mitigation efforts. If we save money today, we will have a lot more to pour into remediation or adaptation strategies in 100 years. The Club Med Grandparents would approve.
Another giant in this field, Sir Nicholas Stern (Baron Stern of Brentford) of the London School of Economics, has a very different opinion about discount rates. In his magisterial 2006 study, Stern Review on the Economics of Climate Change, Professor Stern uses a discount rate of 0.1%.
At this low of a rate, it makes sense to remediate today to counter the future effects of climate change; future dollars are not worth so much more than present ones ($100 in 2019 equals $111 in 2119 at a 0.1% discount rate).
While this approach works better from a climate change remediation standpoint, it flies in the face of the concept of TVM, axiomatic in the economic world for centuries, and also leads to other conceptual problems in the field of resource allocation.
Which of these esteemed gentlemen is correct? Nordhaus’s work has been used as ammunition to take no climate action by enthusiasts of the status quo (mainly employed in the energy industry and ancillary energy-intense industries) even though Nordhaus himself believes humanity needs to act to stave off the “negative externalities” of climate change. Sir Stern’s study raised an enormous amount of discussion when it was published, but lately seems to have very little impact on policy makers’ decisions.
Continue onto Part II of this series to see why I think both these high-IQ, high-prestige guys are wrong…