Former U.S. Treasure Secretary Henry Paulson's recent warning that "We're staring down a climate bubble that poses enormous risks to both our environment and economy" and his call for a carbon tax brings up an important question. How do we assess the benefits to future generations from taking action on climate change now, especially benefits that may be decades or even centuries away?
To answer this question, it's necessary to consider what's known as the "discount rate" on such policies.
Consider a simple example. Suppose an individual is going to receive $1.10 in the future, say a year from now, and that the interest rate on risk-free assets is 10 percent. That would allow the person to invest $1 today and, at a 10 percent interest rate, receive $1.10 a year from now. So when the interest rate is 10 percent, the present value of a certain promise of earning $1.10 in a year is $1.00. Stated another way, an individual would only be willing to pay $1 for a promise of $1.10 a year later when the interest rate is 10 percent.
This formula can be extended to multiple years, while the payments can vary across years, and so on, so it can be generalized to handle almost any stream of benefits (or costs) over any number of years. But a key factor in determining the present value of future benefits is the interest rate, also known as the discount rate. It tells us how much to discount future benefits when calculating the present value.
Notice that as the discount rate goes up, say to 20 percent, the present value of future benefits falls. Thus, as the discount rate rises, future benefits are worth less today (that is, they are discounted more).
The problem in assessing the present value of climate policy that will benefit future generations decades or centuries from now is that we do not have information on very long-term discount rates. However, a recent paper by finance professors Stefano Giglio, Matteo Maggiori and Johannes Stroebel makes use of a unique data set that allows insight into this question.
In particular the authors use data on leaseholds, which are "temporary, pre-paid and tradable ownership contracts with maturities ranging from 99 to 999 years," and compare them to perpetual ownership contracts known as freeholds. As they explain, comparing very long-term leaseholds to freeholds "is informative about the implied discount rates of agents trading these housing assets.
This allows us to gather information on discount rates much beyond the usual horizon of 20-30 years spanned by bond markets."
The authors find that the long-run discount rate for housing is 2.6 percent, a rate that is lower than many analysts have asserted in the past. Thus, we "are more willing than previously thought to invest today for the benefit of future generations."
That would be encouraging news for those like Henry Paulson who believe that the time to take action is now, but he is a lonely voice among Republicans, and it's hard to see much happening in a political environment where progress on climate change looks difficult.