Thursday, February 14, 2008

Cost-Benefit Analysis, Discounting, and Climate Change

I wrote a paper last semester on the notion of discounting future damage (I'll explain what this means below), and I wanted to revisit the issue now that I've done a little more research, to see if I still agree with what I wrote then. Basically, my paper examined how our views of the proper role of discounting are dependent on our views about what social policy is trying to achieve, and what kind of problem climate change poses. Rather than putting my whole paper online and critiquing it, I'm going to split it up into pieces and post each separately. In my paper I examined four paradigms: (1) The goal of social policy should be to allocate resources to their most efficient uses, and climate change represents a challenge to accomplish this task in a changing world; (2) The goal of social policy should be to maximize the overall good, and climate change represents an obstacle in the way of achieving this goal; (3) Climate change represents an externality, and the goal of a climate policy should be to internalize the externalized costs; (4) Climate change represents an overenclosure of the commons, and the goal of a climate policy should be to remedy this injustice. In this post, I will first go over what I mean by "discounting future damage," and then I will address the first paradigm listed above.

So how does discounting play into discussions about climate change? The most significant impacts of climate change will not occur for a significant amount of time: we're talking decades or even centuries. The issue is how important that damage is compared to the equivalent amount of damage today. In his essay, "Global Climate Change: A Challenge to Policy," Kenneth Arrow wrote that the dispute "...surrounds the appropriate value for the social rate of time preference. This...allows for discounting the future simply because it is the future, even if future generations were no better off than we are. The Stern Review [a report released by economist Nicholas Stern discussing the effects of global climate change on the world economy] follows a considerable tradition among British economists and many philosophers against discounting for pure futurity. Most economists take pure time preference as obvious." So when we talk about discounting future damage, what we're concerned with is whether or not it's acceptable to treat future damage as being less important, just because it's going to occur in the future.

So with that in mind, let's look at the paradigm of cost-benefit analysis: policy should allocate social resources in the most efficient manner, and climate change just represents a challenge for doing that. In its most rudimentary form, cost-benefit analysis is a tool which allows decision makers to allocate resources in the way that best matches some relevant set of preferences. For social decision makers, the relevant set of preferences would clearly be those of society as a whole. Since groups are composed of individuals, advocates of the cost-benefit approach feel that it is reasonable to extrapolate society's preferences from the preferences of individuals. This view is implicit in the position taken by economist Jerry Taylor, who favors discounting future damage at a rate of 5% per year, because it "...matches the return on Treasury bills - or, put another way, [it is] the figure people apply themselves when considering the value of money today versus the value of money tomorrow."

Because the simple cost-benefit perspective considers society as if it were a single decision maker, needing only to allocate its own resources according to its preferences, it is immediately clear why discounting would seem obvious. The existence of a preference for value sooner rather than later is a basic economic assumption which is rooted in cold empirical fact. From this mindset, the question is not whether to use a discount rate, rather what discount rate to use. Some, like Jerry Taylor, use the discounting practices of the current marketplace. Others, like economists Richard Newell and William Pizer, try to predict how market discounting practices will vary over the discounting period, suggesting a plausible range of 2-7%. But to debate the validity of using discounting practices at all would be like asking a banker whether she thought she should charge interest on a loan, or asking an investor whether he cared about getting a return on his money.

So if we accept the view sketched above, it's clear that discounting is not only acceptable, but almost obvious. But what should we think of this view? I want to offer a few objections. First, cost-benefit analysis doesn't properly account for the individuality of its subjects, and does not take into consideration the idea that individuals should not be sacrificed for the sake of others. Second, cost-benefit analysis supposes that all harms can be quantified according to a single metric, which doesn't seem right. Third, even if we ignore the first two problems, it seems like discounting is problematic when you consider the goals of cost-benefit analysis. Let me flesh these out a little.

The first objection is basically taken from Anarchy, State, and Utopia, where Nozick writes, "...there is no social entity with a good that undergoes a sacrifice for its own good. There are only individual people, with their own individual lives. Using one for the the benefit of others, uses him and benefits the others. Nothing more. What happens is something is done to him for the sake of others. Talk of an overall social good covers this up...To use a person in this way does not sufficiently respect and take account of the fact that he is a separate person, that his is the only life he has. He does not get some overbalancing good for his sacrifice, and no one is entitled to force this upon him..." I think Nozick is absolutely right here; we can't weigh future people's interests and current people's interests as if they were all held by the same person. Some notion of proper respect for each group as ends in themselves seems necessary, and the paradigm discussed here clearly lacks that.

The second objection, that a single metric is a suspicious way to evaluate wellbeing, is taken from an essay, "Values in the Economics of Climate Change," where Michael Toman wrote, "One other critique of climate change economics as a guide to policy involves the use of a single-dimension new benefit measure for evaluating different outcomes. This reflects the standard assumption in economics that all costs and benefits are commensurable and interchangeable once expressed in a common metric (a monetary metric as a representation of unobservable utility). There may be serious measurement problems in implementing such a reductionist metric, but as a concept the notion of full tradeoffs and thus full potential compensability of losses from climate change is ubiquitous in the economic model. This view differs from alternatives that see different kinds of values as less commensurable, e.g., some losses of natural beauty or function simply cannot be compensated by other welfare gains." Personally, I tend to think that these latter kinds of views are probably closer to being right. For example, if the Hindus of India are forced to abandon the Ganges as a result of climate change, what kind of compensation could we reasonably expect them to be satisfied with?

But even if we ignored the fact that the cost-benefit model is ethically suspect, and that comparing every harm according to the same metric is methodologically suspect (never mind the fact that we could probably never conduct the kind of calculation necessary), there would still be another problem. The third objection arises from the fact that calculations of "costs and benefits" are supposed to reflect utility, and therefore social preferences. The problem is that, as we discussed earlier, the cost-benefit model is perfectly comfortable with the idea of discounting. In his essay, "Environmental Risk, Uncertainty and Intergenerational Ethics," Kristian Skagen Ekeli pointed out that "To discount the future implies that current interests and preferences count for more than those of future generations." When we say that future damage should be discounted, what we're basically saying is that "society," which is supposedly neutral between its individual members, prefers current people to be happy over future people, simply because they live earlier. How this makes sense is beyond me. It seems that if we were trying to allocate resources to impartially reflect their most efficient uses, we would need to weigh people's interests as being equally significant.

So hopefully those objections demonstrate two things. The first is that cost-benefit analysis is a really crappy way to deal with the issue of climate change. But if we use it anyway (which I suspect people will do, because that's how economics is done nowadays), then we shouldn't discount future damage. To do so would treat future people as if they mattered less than present people, and that seems obviously unacceptable. I am, of course, conspicuously ignoring the Non-Identity Problem completely, and I want to deal with that issue, but I guess I'll leave that for later.


Anonymous said...

People discount the future and demand interest for foregoing present consumption, because they do not want to live with unsatisfied desires that are "eating at" them while they wait for their money to come back with interest. But the future is not discounted because it is inherently less valuable. It could be, but it could also be equally valuable or more valuable. For example, a newborn has a very small capacity for either happiness or sorrow. He would be well-advised to value his adult happiness much more than his present experiences. Nor do people discount the future of their progeny merely because it lies in the future. Our descendants are simply other people, like everyone else living presently. If they are loved, then their welfare is taken into account. That they may not yet exist is but an accident, irrelevant to moral calculations. We can cultivate disinterested benevolence, required by utilitarianism, even toward them.

Steven Landsburg posed a similar problem in his book Fair Play on which I attempt to shed some light here.

Danny Shahar said...

I don't want to say that you're wrong, because I'm honestly not well enough versed in the theory of pure time preference. Instead, I'll say that in taking that position, I think you're coming down on the opposite side of a lot of Austrian thinkers, including Mises and Rothbard. I might be wrong about that, and further, those guys might have been wrong about time preference. I'm honestly not well enough versed in the theory to defend it against an alternative conception. So instead, I'll point you to section 2 of chapter 18 of Human Action, and simply tell you that I was under the impression that time preference wasn't a horribly controversial concept.

On the issue of a proper way to think about future people and discounting, I'd simply point out that cost-benefit calculations aren't based on how some individuals value the fates of other individuals. They're based on what happens to those individuals themselves. So it wouldn't be enough to take account of how much currently existing people care about future people. We'd also need to take into account what actually happens to those people, and factor their costs and benefits into the equation. That was the point I was trying to make at the end of the post. Does that help at all?

Anonymous said...

It is controversial. Bob Murphy did not like it; Jörg Guido Hülsmann has problems with it, and I defend the time preference theory of interest here against his attacks; Israel Kirzner said he did not understand Mises's pure time preference theory of interest ("It is a very difficult chapter in Mises."); etc.

Danny Shahar said...

Fair enough; I personally don't see what the big deal would be about, but again it's not really my field. All I'll say is that even if time preference does not exist, the ethical problems with factoring future people's costs and benefits into a cost-benefit analysis as they are valued by current people should be enough to make my point.

Ogemaniac said...

I have always been suspect of discounting when applied to future generations.

Discounting in the "market" is rooted in our individual time-preference for money, the "market" value only representing a summation of what many individuals believe. There are several reasons that individuals have time-preferences: we may die before we collect, the institution we are loaning to may default, uncertainty about the future, and straight-up irrationality. However, most of these really apply at the society level. Our children will certainly be there to collect whatever we leave behind.

If you look at the cost-benefit analyses concerning climate change, one thing that is striking is the assumption that growth in individual incomes will continue unabated, and that our grand-children will be filthy stinking rich. If this were the case, it might make sense to discount a little...but how sure that this will come to pass? I feel that it is more likely that they will be richer than us in some ways, and poorer than us in others...and the latter will be mostly our fault.

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