Page:Technical Support Document - Social Cost of Carbon, Methane and Nitrous Oxide Interim Estimates under Executive Order 13990.pdf/18

 consideration. In calculating the SC-GHG, the stream of future damages to agriculture, human health, and other market and non-market sectors from an additional unit of emissions are estimated in terms of reduced consumption (or consumption equivalents). Then that stream of future damages is discounted to its present value in the year when the additional unit of emissions was released. Given the long time horizon over which the damages are expected to occur, the discount rate has a large influence on the present value of future damages. However, the choice of a discount rate also raises highly contested and exceedingly difficult questions of science, economics, ethics, and law.

In 2010, in light of disagreements in the literature on the appropriate discount rate to use in this context, and uncertainty about how rates may change over time, the IWG elected to use three discount rates to span a plausible range of certainty-equivalent constant consumption discount rates: 2.5, 3, and 5 percent per year. The IWG at that time determined that these three rates reflected reasonable judgments under both descriptive and prescriptive approaches to selecting the discount rate.

The 3 percent value was included as consistent with estimates provided in OMB’s Circular A-4 (OMB 2003) guidance for the consumption rate of interest. The IWG found that the consumption rate of interest is the correct discounting concept to use when future damages from elevated temperatures are estimated in consumption-equivalent units as is done in the IAMs used to estimate the SC-GHG (National Academies 2017). The upper value of 5 percent was included to represent the possibility that climate-related damages are positively correlated with market returns, which would imply a certainty equivalent value higher than the consumption rate of interest. The low value, 2.5 percent, was included to incorporate the concern that interest rates are highly uncertain over time. It represents the average certainty-equivalent rate using the mean-reverting and random walk approaches from Newell and Pizer (2003) starting at a discount rate of 3 percent. Using this approach, the certainty equivalent is about 2.2 percent using the random walk model and 2.8 percent using the mean reverting approach. Without giving preference to a particular model, the average of the two rates is 2.5 percent. Additionally, a rate below the consumption rate of interest would also be justified if the return to investments in climate mitigation are negatively correlated with the overall market rate of return. Use of this lower value was also deemed responsive to certain judgments based on the prescriptive or normative approach for selecting a discount rate and to related ethical objections that have been raised about rates of 3 percent or higher. Further details about the process for selecting these rates is presented in the 2010 TSD (IWG 2010). Finally, it is important to note that, while the consumption discount rate is the conceptually correct rate for discounting the SC-GHG, and the three rates originally selected were based on this concept, the latest data as well as recent discussion in the economics literature indicates that the 3 percent discount rate used by the IWG to develop its range of discount rates is likely an overestimate of the appropriate discount rate and warrants reconsideration in future updates of the SC-GHG.

This section discusses three issues related to the selected discount rates: (1) why the social rate of return to capital, estimated to be 7 percent in OMB’s Circular A-4, is not appropriate for use in calculating the SC-GHG, (2) new evidence on the consumption rate of interest, which may inform the future updates to the SC-GHG, and (3) analytic consistency across discounting within an analysis.

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