Discounting climate change damages: Working note for the Stern review
Hepburn, C. (2006), mimeo, October.
Keywords: Climate Change / Declining discount rates / Discounting / Stern Review / Time inconsistency
This working note provides a basic overview of discounting in the context of climate change policy. After defining the social discount factor and social discount rate in terms of shadow prices (section 2), and noting the limitations of cost-benefit analysis for climate change (section 3), the determination of efficient social discount rates is discussed given: the impact of uncertainty about future economic conditions (section 4.2), the effect of heterogeneous time preferences (4.3) and time inconsistency issues (4.4). Fairness between generations is then discussed (5.1) and some alternatives to using discount factors are considered (5.2). It is concluded that the shadow discount rate should be declining over time to reflect the certainty-equivalent path. It is also argued that the underlying utility discount rate is very small, possibly zero to a first approximation.