Thursday, June 29, 2017


Debates on policies to combat climate change often include a collection of long running arguments around the cost of capital, or the time discount rate for comparing costs and benefits. These were prominent in arguments over the recommendations of the Stern Review, mainly in attempts at a cost benefit analysis (CBA) of the public policy case for action to mitigate climate change. But assumptions on cost of capital do also matter a lot in what are now the very real questions of comparing alternative investments to reduce emissions. And of course the actual cost of capital employed will have a major impact on the affordability of future energy use, and prices to consumers. Sadly this is one of the areas where the disciplines of economics and finance have been at their weakest, in failing to provide a rigorous and consistent approach to the subject, at least in relation to the public discourse.

Let us start with the public policy arguments around climate policies, and the claim sometime made that the case for action depends on the assumed discount rate, the rate at which we discount the significance of future benefits or costs. One version of this argued that the costs calculated by Stern[1] could only justify action to mitigate climate change if the time discount rate could be assumed to be 1% or lower. Given that even a modest probability of human extinction (or more realistically of the massive forced reductions in population of the kind against which some environmentalists warn us) might be considered to have a near infinite cost, the approach was always intrinsically unlikely to convince anyone. At times, much of the debate on this subject resembled nothing so much as the supposed[2] discussions of mediaeval scholars as to how many angels could stand on the head of a pin.

The real problem in these arguments was the weakness of a cost benefit approach in dealing with systemic risks and possible catastrophes on a long term and global basis. CBA is usually targeted on situations where the alternatives can in some sense all be considered “at the margin”, Inter alia it became increasingly clear that the real problem lay less in evaluating notional GDP projections in alternative climate scenarios, and much more in the climate induced consequences, including migration and conflict. These considerations were compounded by the problem CBA has in dealing with uncertainty and with risks that are not amenable to simple probability quantification. Add to that the nature of the potential risks, which are on an unimaginable scale, and it ought to be clear why the calculation of the costs of a dystopian future, for comparison against an almost equally impossible set of counterfactuals as a baseline, is a rather futile exercise.

Economic models designed for fairly simplistic macro-economic analysis (and they often prove to be not very good even for this relatively straightforward task) were applied to timescales and hypothetical events well beyond their design capability, and it was quickly recognised that they did not come remotely close to capturing the true nature of climate risk. What is now accepted, and is implicit in the international acceptance of the Paris agreement, is that the risk of climate catastrophe is simply too big to be borne, and that mitigatory or remedial action is therefore a necessity.

Fortunately this part of the argument over climate policy is now settled in the public domain, with almost all[3] nations united in their recognition of the need for actions of the kind indicated in Paris[4].  Cost of capital arguments were ultimately of little importance in determining the fundamental imperative for policy action in relation to climate. Even so the arguments were revealing in the differing attitudes they uncovered. Nigel Lawson’s polemic[5] against science driven climate policies argued strongly that we should care increasingly less for the futures of our grandchildren or more remote generations, arguing for much higher discount rates, of the order of 10% or more, largely on the grounds that these were closer to the target rates applied in business decision making.

The impact of discounting at such high rates makes damages a 100 years hence worth a very small fraction in terms of today’s values. Unfortunately for this argument, and as we suggest above, the scale of the perceived risk – sometimes stated in worst case scenarios as a forced population reduction of many billions - can also be described as almost infinitely large, and this is clearly the position implicit in what we might describe as the “Paris consensus”.

The Lawson position was, I suspect, based on a profound misunderstanding of how business works, especially in extrapolation of the most superficial approaches to investment appraisal. It may reflect multiple confusions over the way businesses treat investment appraisal, the debt and equity balance, use of real or nominal rates, and the appropriate assumptions about market correlation, which are a major feature of the standard CAPM model of finance. Another interesting corollary of using a high discount rate would, of course, be that it would not be necessary to set aside any significant sums today for nuclear or other decommissioning in 100 years time. Needless to say this is not an approach that is argued very often.

Lawson’s hypothetical rates are so far from the actual rates of return achieved in most business, most of the time, that we must assume one of two things. Either business is incompetent in investment appraisal, or Lawson just does not understand the subject. As he was perhaps one of the less able Chancellors of modern times, and remains someone who clearly fails to get to grips with climate science or the interpretation of statistics, the latter seems more likely.
The reality seems to be that, under the right conditions, major projects can be financed at very low real rates of interest. But that is an important issue to which I hope to return.  The subject remains important in practical terms, both for choosing investments and making them affordable.

[1] To give credit to Stern he never proposed CBA as a main driver of policy, and his post-Review thinking on the subject gave much more weight to the catastrophe avoidance arguments.
[2] In fact this may be an early modern fabrication, or simply an illustration of a category error in a more substantial metaphysical discussion.
[3] The exceptions being Trump’s USA, and Nicaragua, but the latter on the grounds that the proposals did not go far enough.
[4] The reality of actions is of course far less clear, but there is progresss.
[5] An Appeal to Reason.  Nigel Lawson. Duckworth Overlook, 2008.

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