Climate Legacy Initiative Student Researchers Blog

The concepts of discounting and the time value of money are not new. Anyone who takes a course in microeconomics or business will find the basic concept somewhere in their text around chapter two. Who can forget Wimpy’s famed quip, “I’ll gladly pay you Tuesday for a hamburger today?” So how then has this economic concept found its way to the forefront of environmental discourse, especially around intergenerational equity and climate change?

To answer requires a brief explanation of the two economic terms implied in Mr. Wimpy’s hamburger deal. The time value of money is based on the premise that an individual prefers an amount of cash today rather than at any time in the future, assuming all else equal. This is because money today can be invested and earn a rate of return. For example an individual who deposit cash in a high yield savings account with a 4% interest rate will earn 4% each year, adding value to the principle. If instead the individual receives the same amount of money a year later, he or she will not have had the opportunity to earn 4% interest that year. Therefore, money in the future (even when paying for hamburgers) is worth less than money today.

But how much less is it worth? This calculation is called discounting. Discounting is defined as the process of finding the present value of an amount of money spent (cost) or received (benefit) in the future. This economic theory became a matter of interest when President Clinton signed Executive Order 12866, requiring federal agencies to analyze the costs and benefits of all rulemaking. The cost benefit analysis uses discounting to compare future costs and benefits in present value. Circular A-4, issued by the Office of Management and Budget (OMB) under President Bush, suggests default discount rates of 3% and 7%. But in the context of intergenerational discounting — discounting costs and benefits accrued to future generations — the Circular requires agencies to use a lower but positive rate. This is the heart of the debate between environmentalists and economists. A positive discount rate applied to the value of money over a long time period results in an arbitrarily low present value. This mathematical reality allows agencies to easily justify not spending money today to protect the rights of future generations.

Cass Sunstein and Arden Rowell illustrated this point in On Discounting Regulatory Benefits: Risk Money and Intergenerational Equity.¹ Assume you value a human life at $8 million dollars and you must decide whether or not to choose a policy that will save 100 individuals in 100 years. If you use a discount rate of 10% one individual life saved in 100 years valued in present money value would only be worth $581. The federal agency would be justified to spend only $58,100 to save those 100 future lives.

This is where climate change fits into the discussion. Because the greatest costs of global warming will be felt in the distant future, policymakers must do this same type of analysis. Regulatory actions to address climate change today will benefit future generations more than present day American citizens. Given Sunstein and Rowell’s illustration, one can easily see that discounting becomes a menacing hurdle when searching for ways to protect future generations from climate change damages.

One strategy used to overcome this obstacle is to chip away at the economic theory underlying discounting. Another way is to look again to the language of the Executive Order which allows for modification to the benefit cost analysis. It does so by suggesting two approaches, either modifying the discount rate or supplementing the analysis with an explicit discussion of equity issues. This departure from a traditional cost benefit analysis, however, was rejected by the Fifth Circuit in Corrosion Proof Fittings v. EPA when it invalidated EPA’s ban on asbestos.²

The court concluded that the agency’s cost benefit analysis was arbitrary and capricious because it gave too much weight to the unquantifiable benefits of future health benefits and saved lives. We now know from subsequent jury awards that the value of this unquantifiable benefit is enormous — large enough to bankrupt the entire asbestos industry.

Another strategy is to realize that relying on cost benefit analysis for regulatory decisions is a policy choice³ in its own right. Once we realize it is a decision and not inevitable, it is possible to choose not to use it. The federal government has already done this in a variety of situations.
For instance, OMB chooses to automatically exclude Homeland Security regulations from cost benefit analysis. This is a policy choice to protect Americans against terrorism regardless of cost. Likewise OMB does not apply cost benefit analysis to agency rules that de-regulate. In contrast, OMB requires EPA to provide a benefit cost analysis for every rule promulgated after 1995. It is their policy to substitute their own monetary assessment for benefits the EPA has not quantified and to “work with the EPA to reduce uncertainties in those valuations.” (SOURCE)

The result is that Homeland Security does not have to justify its actions based on monetized values while EPA does. There is no logical policy distinction between not applying cost benefit analysis to decisions to regulate and not applying it to decisions not to regulate: a decision to stop regulating imposes costs and benefits on society just as a decision to regulate. The difference here is in one case the government decided yes and the other no.

Clearly discounting is not the issue. It is just an analytical tool, a useful element of a cost benefit analysis. While commentators can debate the theory of discounting and its application, tweaking the formula till it reveals the preferable policy decision, it is not entirely necessary. Once we realize that the government can and does forgo benefit cost analysis for certain rules, it becomes possible to imagine a different decision making regime — one that allows the present generation to contemplate rules that can and will protect future generations.

1. Cass Sunstein and Arden Rowell, On Discounting Regulatory Benefits: Risk Money and Intergenerational Equity, 74 U. Chi. L. Rev. 171,172 (2007).
2. 947 F.2d 1201 (5th Cir. 1991).
3. Frank Ackerman & Lisa Heinzerling, Pricing the Priceless: Cost-Benefit Analysis of Environmental Protection, 150 U. Pa. L. Rev. 1553, 1563 (2002).