As I brought up in the first article in this two-part series, the choice of putting off spending money on climate change mitigation investments is similar to the grandparents that raid their grandkid’s college fund for a trip to Club Med. While morally quite questionable, it is perfectly defensible using standard financial theory and a concept called a “discount rate”.
In the minds of many, the future of human civilization is riding on this concept of discount rate, so if you’re shaky on what a discount rate is and why it might be important, I’d suggest going back to the first article to get a refresher.
Two giants in the field of climate change economics, William Nordhaus of Yale and Sir Nicholas Stern of the London School of Economics, have two very different ideas about discount rates. Nordhaus prefers a relatively high discount rate — 3% — the effect of which is to encourage humanity to put off spending on climate change mitigation for as long as possible.
Stern believes that a very low rate — 0.1% — is the proper one to use. Using this discount rate would spur climate change mitigation efforts in the near-term, but causes other problems; specifically, it raises the question of why should the 10-year “risk-free” be much higher than the 100-year “risky” rate.
Which of these august personages is correct? Here is my take.
The “Right” Discount Rate Doesn’t Exist
I do not have a Nobel Prize – fake or otherwise – and I am not an LSE Economist and life peer of the British Empire, but I assure you that both esteemed gentlemen are wrong about discount rates.
While their respective choices of discount rates are different, both make the same fundamental error: conceiving of the long-run socioeconomic environment in terms of continuous, incremental change.
The easiest way to illustrate this error is by looking at the effects of a sudden geographical move.
I am a U.S. citizen and save money in U.S. depository accounts. I understand what a fair rate of interest is to earn on my money. My views about this rate are based on my understanding of the economic conditions of the United States.
If I were to move to South Africa, convert my savings into rand, and deposit those rand into a South African bank, I would not expect the interest rate on my new deposit accounts to be related to the interest rate on my old U.S. deposit accounts. The strengths and weaknesses of the South African economy is completely different from those of the United States.
In this example, I have assumed a sudden move from one national regime to another. I have no expectations for a continuation of American interest rates in South Africa because I understand that the conditions in place in both nations are very different.
In the case of climate change, the discontinuous shift will not be a geographic one but a temporal and environmental one.
Once fecund farmland will fall fallow. Once rich seas will empty of life. Once economically and socially important gateway cities will be forced to be abandoned. The carrying capacity of our land will be reduced. These changes will occur faster than we can presently conceive – as if we suddenly stepped out of one world and into another.
Assuming that there should be a continuity between discount rates under two vastly different ecological regimes is as nonsensical as assuming U.S. demand deposits will pay the same interest as South African ones.
Nordhaus is wrong. Stern is wrong.
Approaching a Tipping Point
Science tells us that complex systems exhibit phenomenally stable conditions until those systems reach certain tipping points. Once those tipping points are breeched, the complex system falls into a different phenomenally stable state. You can read about an excellent example of this effect in this excellent Quanta article about a bass pond in Wisconsin.
A recent study suggests a 93% chance that the earth will see a rise of greater than four degrees Centigrade by 2100 – twice the target level of the Paris Accord and catastrophic under any reasonable definition. In so doing, the climactic system will breech important tipping points and fall into a very stable new regime.
The study’s authors equate the economic effects of such warming to a never-ending Great Depression – never ending because of the stability of the new regime.
Perched at this time in human civilization, you – gentle reader – have the choice of how best to act to build and preserve intergenerational wealth in the 21st century. Facing a 93% chance of catastrophic climate change, are you going to continue betting on the status quo?
It is time to invest in a new paradigm. Intelligent investors take note.