Navigating the trade-offs between investments for growth and climate action: the role of social discount rates

• Greenhouse gas emissions have enduring effects, necessitating that their impact be assessed across generations. The social time preference discounting approach has become conventional for this purpose.
• Social time preference is usually derived via the Ramsey formula, which expresses the social discount rate (r) as a function of the pure rate of time preference (ρ), the elasticity of the marginal utility of consumption (η), and the growth rate of per capita real consumption (g): r = ρ + ηg. Often ρ is set close to zero, η usually falls between 1 and 1.5, and g is proxied by per capita growth of GDP. Based on historical global GDP growth of about 1.9% per year in the past six decades, a social discount rate of up to 3% is often used and considered reasonable.
• The social cost of carbon (SCC) measures the monetary value of the future stream of net damages associated with adding one ton of greenhouse gas to the atmosphere in a given year, and therefore it reflects the societal net benefit of reducing emissions by one ton at present. A social discount rate is used to calculate the SCC by discounting future damages to their present value at the time emissions occur.
• The social discount rate is also used in integrated assessment models (IAMs). These tend to assume that representative agents choose climate policies to maximize their social welfare (represented by the net present value [NPV] of intertemporal utilities), and in which the social discount rate is a key parameter.
• Low- and middle-income economies exhibit above-average annual growth in real GDP per capita, leading to a higher social discount rate. This reduces the NPV of future net returns and makes investments with more immediate returns more attractive than those with more benefits in the longer term. Thus, the attractiveness of long-term climate mitigation investments is reduced relative to immediate growth-focused projects in developing countries by virtue of the social discount rate applied.

To make the global optimum (addressing climate change) locally optimal in fast-growing developing countries with relatively higher implied social discount rates, local climate action needs to be incentivized. Two strategies can be employed to this end. First, lowering financing costs for climate investments can make climate projects with payoffs in the long term more attractive. Second, future returns on climate investments can be enhanced, e.g., if developed countries or the multilateral development banks agree to provide future payments for investments that reduce greenhouse gas emissions or restore nature’s capacity to sequester carbon.