Does economic analysis shortchange the future?

Decisions made today usually have impacts both now and in the future. In the environmental realm, many of the future impacts are benefits, and such future benefits — as well as costs — are typically discounted by economists in their analyses.  Why do economists do this, and does it give insufficient weight to future benefits and thus to the well-being of future generations?

This is a question my colleague, Lawrence Goulder, a professor of economics at Stanford University, and I addressed in an article in Nature.  We noted that as economists, we often encounter skepticism about discounting, especially from non-economists. Some of the skepticism seems quite valid, yet some reflects misconceptions about the nature and purposes of discounting.  In this post, I hope to clarify the concept and the practice.

It helps to begin with the use of discounting in private investments, where the rationale stems from the fact that capital is productive ­– money earns interest.  Consider a company trying to decide whether to invest $1 million in the purchase of a copper mine, and suppose that the most profitable strategy involves extracting the available copper 3 years from now, yielding revenues (net of extraction costs) of $1,150,000. Would investing in this mine make sense?  Assume the company has the alternative of putting the $1 million in the bank at 5 per cent annual interest. Then, on a purely financial basis, the company would do better by putting the money in the bank, as it will have $1,000,000 x (1.05)3, or $1,157,625, that is, $7,625 more than it would earn from the copper mine investment.

I compared the alternatives by compounding to the future the up-front cost of the project. It is mathematically equivalent to compare the options by discounting to the present the future revenues or benefits from the copper mine. The discounted revenue is $1,150,000 divided by (1.05)3, or $993,413, which is less than the cost of the investment ($1 million).  So the project would not earn as much as the alternative of putting the money in the bank.

Discounting translates future dollars into equivalent current dollars; it undoes the effects of compound interest. It is not aimed at accounting for inflation, as even if there were no inflation, it would still be necessary to discount future revenues to account for the fact that a dollar today translates (via compound interest) into more dollars in the future.

Can this same kind of thinking be applied to investments made by the public sector?  Since my purpose is to clarify a few key issues in the starkest terms, I will use a highly stylized example that abstracts from many of the subtleties.  Suppose that a policy, if introduced today and maintained, would avoid significant damage to the environment and human welfare 100 years from now. The ‘return on investment’ is avoided future damages to the environment and people’s well-being. Suppose that this policy costs $4 billion to implement, and that this cost is completely borne today.  It is anticipated that the benefits – avoided damages to the environment – will be worth $800 billion to people alive 100 years from now.  Should the policy be implemented?

If we adopt the economic efficiency criterion I have described in previous posts, the question becomes whether the future benefits are large enough so that the winners could potentially compensate the losers and still be no worse off?  Here discounting is helpful. If, over the next 100 years, the average rate of interest on ordinary investments is 5 per cent, the gains of $800 billion to people 100 years from now are equivalent to $6.08 billion today.  Equivalently, $6.08 billion today, compounded at an annual interest rate of 5 per cent, will become $800 billion in 100 years. The project satisfies the principle of efficiency if it costs current generations less than $6.08 billion, otherwise not.

Since the $4 billion of up-front costs are less than $6.08 billion, the benefits to future generations are more than enough to offset the costs to current generations. Discounting serves the purpose of converting costs and benefits from various periods into equivalent dollars of some given period.  Applying a discount rate is not giving less weight to future generations’ welfare.  Rather, it is simply converting the (full) impacts that occur at different points of time into common units.

Much skepticism about discounting and, more broadly, the use of benefit-cost analysis, is connected to uncertainties in estimating future impacts. Consider the difficulties of ascertaining, for example, the benefits that future generations would enjoy from a regulation that protects certain endangered species. Some of the gain to future generations might come in the form of pharmaceutical products derived from the protected species. Such benefits are impossible to predict. Benefits also depend on the values future generations would attach to the protected species – the enjoyment of observing them in the wild or just knowing of their existence. But how can we predict future generations’ values?  Economists and other social scientists try to infer them through surveys and by inferring preferences from individuals’ behavior.  But these approaches are far from perfect, and at best they indicate only the values or tastes of people alive today.

The uncertainties are substantial and unavoidable, but they do not invalidate the use of discounting (or benefit-cost analysis).  They do oblige analysts, however, to assess and acknowledge those uncertainties in their policy assessments, a topic I discussed in my last post (“What Baseball Can Teach Policymakers”), and a topic to which I will return in the future.


Green Jobs

The January 12, 2009 issue of The New Yorker includes a well-written and in some ways inspiring article by Elizabeth Kolbert, profiling Van Jones, founder and president of Green for All. In the article, “Greening the Ghetto: Can a Remedy Serve for Both Global Warming and Poverty,” Kolbert includes the following passage:

When I presented Jones’s arguments to Robert Stavins, a professor of business and government at Harvard who studies the economics of environmental regulation, he offered the following analogy: “Let’s say I want to have a dinner party. It’s important that I cook dinner, and I’d also like to take a shower before the guests arrive. You might think, Well, it would be really efficient for me to cook dinner in the shower. But it turns out that if I try that I’m not going to get very clean and it’s not going to be a very good dinner. And that is an illustration of the fact that it is not always best to try to address two challenges with what in the policy world we call a single policy instrument.”

That brief quote generated a considerable amount of commentary in the blogosphere, much of it negative, and some of it downright hostile. This surprised me, because I didn’t consider the proposition to be controversial, and I had chosen my words carefully, simply stating that “it is not always best to try to address two challenges with … a single policy instrument.” Two activities — each with a sensible purpose — can be very effective if done separately, but sometimes combining them means that one does a poor job with one, the other, or even both.

In the policy world, such dual-purpose policy instruments are sometimes a good, even great idea (gas taxes are an example), but other times, they are not. Whether trying to kill two birds with one stone makes sense depends upon the proximity of the birds, the weapon being used, and the accuracy of the stoner. In the real world of important policy challenges — such as environmental degradation and economic recession — these are empirical questions and need to be examined case by case, which was my point in the brief quote. Since my further explanation of this point in the green jobs context (in an interview that lasted 30 to 60 minutes — I don’t recall) did not find its way into Ms. Kolbert’s article (no fault of hers — she had plenty of sources, plenty of material, and limited space), let me provide that explanation here.

In 1990, when Congress sought to cut sulfur dioxide (SO2) emissions from coal-fired power plants by 50% to reduce acid rain, Senator Robert Byrd (West Virginia) argued against the proposal for a national cap-and-trade system, because it would displace Appalachian coal mining jobs through reduced demand for high-sulfur coal. He recommended instead a national requirement for all plants to install scrubbers, which would have increased costs nationally by $1 billion per year in perpetuity.

Fortunately, Senator Ted Kennedy (Massachusetts) recognized that these two problems (acid rain and displaced miners) called for two separate policy instruments. Simultaneous with the passage of the Clean Air Act amendments of 1990, which established the path-breaking SO2 allowance trading program, Congress passed a job training and compensation initiative for Appalachian coal miners, at a one-time cost of $250 million. Acid rain was cut by 50%, $1 billion per year was saved for the economy, and sensible and meaningful aid was provided to the displaced miners. Two different policies were used to address two different purposes. Sometimes that is the wisest course.

What about two current challenges: concern about the environment, in particular global climate change, on the one hand, and the need to turn around the economy, on the other hand? Can “green jobs” be the answer to both?

Will an economic stimulus package — properly designed — lead to job creation in the short term? Yes, but to some degree this will be by moving forward in time the date of job creation, as opposed to creating additional jobs in the long run. Of course, at a time of recession and increasing unemployment, that can be a sensible thing to do. So, by expanding economic activity, an economic stimulus package can surely create jobs — green or otherwise — in the short term.

But will a stimulus package — such as subsidies for renewable energy — create net jobs from the change in the nature of economic activity? The key question here is whether the encouraged economic activities in green sectors are more labor-intensive than the discouraged economic activities in other sectors, such as with a shift to renewables from fossil fuels.

This is considerably less clear, but there are cases where it is likely to be valid. Solar rooftop installation, for example, is labor-intensive. And the greatest consistency between economic stimulus and greening the economy is within the energy-efficiency realm, in particular, activities such as the weatherization of homes and businesses. Such projects are highly labor-intensive, can be done quickly, and will save energy. And, importantly, they will reduce the long-term cost of meeting climate objectives.

But some other areas, such as new green infrastructure, will happen much more slowly — partly because of NIMBY (“not in my backyard”) problems — and so are less consistent with the purpose of economic stimulus. An example of the challenge is presented by the current interest in expanding and improving our national electricity grid.

A more interlinked and better grid is needed for increased reliance on renewable energy sources, which will be needed to address climate change. First, greater use of renewable resources will require an expanded grid just to transmit electricity from the Great Plains, for example, to cities with high demand for power. And, second, this will also require the use of a so-called “smart grid,” so that greater reliance on intermittent sources of electricity, such as from wind farms, can be balanced with cuts in consumer demand when power is scarce.

But the timing of grid expansion — important for the use of renewables and achieving climate goals — is not coincident with the appropriate timing of the economic stimulus. As was reported in an article by Matthew Wald in the New York Times (“Hurdles (Not Financial Ones) Await Electric Grid Update,” January 7, 2009, p. A11), the CEO of the American Transmission Company — which operates in four midwestern states — said that the firm’s most recent major project, a 200-mile transmission line from Minnesota to Wisconsin, took 2 years to build, but 8 years prior to that to win the necessary permits!

Likewise, an article by Peter Behr in Climate Wire (“Green Power Express line gets derailed by patchwork grid rules,” Feburary 12, 2009, p. 1) focuses on the dilemma facing ITC Holdings, the nation’s largest independent electric transmission company, which has been seeking permission from the Federal Energy Regulatory Commission to build a line to bring wind power from the Great Plains to the Midwest and East. The company’s chairman and CEO, Joseph Welch, indicates that a greater hurdle than the necessary money or “even the ever-present citizen opposition to new transmission projects” is a set of rules for interstate transmission lines that effectively prohibits projects that are not immediately required to maintain the grid’s reliability. A project intended to provide future green power does not meet the test.

These are just two examples of the unpleasant reality of the pace of investment and change in this important category of green infrastructure frequently talked about in the context of quick economic stimulus. Surely, economic recovery, increased reliance on renewable sources of energy, and a smarter, inter-connected grid are all important. But that does not mean they are best addressed with a single policy instrument – the economic stimulus package.

So, the strongest support for “green job creation” is with regard to economic expansion, as opposed to changes in the economy. Of course, the key economic question remains whether even more jobs would be created with a different sort of expansion. In any event, while we are expanding economic activity through the economic stimulus package, it makes sense to reduce any tendency to lock in new capital stock that would make it more difficult and costly to achieve long-term environmental goals. But that is very different from claiming that all substitution of green activities for brown activities creates jobs in the long-term.

As the government uses economic stimulus to expand economic activity, it can and should tilt the expansion in a green direction. But rather than a “broad-brush green painting of the stimulus,” this may call for some careful, selective, and well thought-through “green tinting.”

Addressing the worst economic recession in generations calls for the most effective economic stimulus package that can be devised, not a stimulus package that is diminished in effectiveness through excessive bells and whistles meant to address a myriad of other (legitimate) social concerns. And, likewise, getting serious about global climate change will require the enactment and implementation of meaningful, dedicated climate policies, most likely a comprehensive national CO2 cap-and-trade system. These are two serious but different policy problems, and they call for two serious, carefully-crafted policy responses.

After I wrote this brief essay, someone brought to my attention an article posted at Slate by Michael Levi, a senior fellow at the Council on Foreign Relations(“Barking Up the Wrong Tree: Why ‘Green Jobs’ May Not Save the Economy or the Environment,” March 4, 2009). I found Levi’s assessment to be sensible and compelling, but I may be biased by two realities: one is that he and I are fundamentally in agreement; and the other is that we have been professionally affiliated, because he is the co-author of a paper (“Policies for Developing Country Engagement” ) which is part of the Harvard Project on International Climate Agreements, a global research and outreach initiative which I direct. Rather than summarize or repeat any of Michael Levi’s article, I urge you to read it in its entirety at the Slate web address above.


Opportunity for a Defining Moment

The inauguration of Barack Obama as the forty-fourth President of the United States is a defining moment in American history. For most Americans and countless others around the world, this is an inspiring political transition. The question we must face, however, is whether compelling inspiration will lead to effective action. As I wrote in a Boston Globe op-ed (November 12, 2008) one week after election day, environment and energy issues — particularly climate change policy — provide a microcosm of the forces that are shaping and will shape the actions of the new Administration and Congress.

About eight years ago, President-Elect George W. Bush promised to be President for all the people, not just those who had voted him into office. Bush’s ability as Texas Governor to bridge differences across the political aisle provided cause for optimism.

But hope for a centrist and sensible Presidency dissolved under the influence of White House political operative Karl Rove and Vice President Dick Cheney. The Bush Administration moved not to the center, but toward solidifying its base on the political right. Nowhere was this more apparent than in energy and environmental policy, with Vice President Cheney running energy policy, and EPA Administrator Christie Whitman virtually driven from office.

Will the environment and energy team of President Obama respond effectively to the serious challenges that lie ahead? Or will we find that the corporate lobbyists who filled so many key environmental positions in the Bush Administration have simply been replaced by strident advocates from the other end of the political spectrum? In other words, will ideology trump reason?

The first sign of trouble will be if the Administration issues an “endangerment finding” for carbon dioxide, as promised by the Obama campaign, thereby pleasing and solidifying President Obama’s political base, but also playing into the hands of those who oppose climate policy action, tying up progress with litigation, driving up costs, and accomplishing little or nothing.

Ultimately, will the Obama White House work with Congress to develop climate strategies that are scientifically sound, economically sensible, and thereby politically pragmatic? Will the new President –with impressive Democratic majorities in both houses of Congress — take on the difficult task of crafting meaningful climate legislation?

The only politically feasible approach that can make a real dent in the problem is a comprehensive, upstream cap-and-trade system to reduce carbon dioxide emissions 50 to 80 percent below 1990 levels by 2050. The declining cap will increase the cost of polluting, thereby discouraging the use of the most carbon-intensive fossil fuels and providing powerful incentives for energy conservation and technology innovation.

The system could start with a 50-50 split of auctioned and free allowances, gradually moving to 100% auction over 25 years. To establish political support in the short term, free allowances should be targeted to sectors that are most burdened by the policy. And the auction revenue — which will increase over time — can be used to compensate low-income consumers, finance research and development, reduce the federal deficit, or cut taxes.

The best option may be to make the program revenue-neutral by returning all of the auction revenue to citizens through direct cash dividends or annual tax credits. This can go a long way towards making the legislation palatable to Republicans and Democrats alike who are reticent to take any actions that even resemble a tax increase.

By making the overall emissions cap gradually become more stringent over time, costs can be greatly reduced by avoiding premature retirement of existing capital stock, reducing vulnerability to siting bottlenecks, and ensuring that long-lived capital investments incorporate appropriate advanced technology.

Still, the costs of meaningful action will be significant, with impacts on gross domestic product eventually reaching up to 1 percent per year. But the longer the world waits to begin taking serious action, the more ambitious will emission reduction targets inevitably become, as atmospheric greenhouse gases continue to accumulate.

The bottom line is that getting serious about global climate change will not be cheap and it will not be easy. Beware of claims to the contrary. In the midst of a significant economic downturn, with businesses closing and unemployment on the rise, it makes sense for the new Administration to give its greatest attention to economic recovery. There is nothing wrong with sequencing policies. But if current predictions about the consequences of another few decades of inaction are correct, this defining moment provides an important opportunity for serious and sensible action.