Discounting of Long Term Costs: What Would Future Generations Prefer Us to Do?

Decisions with intergenerational consequences may leave future generations worse off (i.e., not be Pareto optimal) if costs and benefits are not discounted correctly. We point out that this happens if the conventional social discount rate is applied to intergenerational costs: with this rate the justification of intergenerational costs (benefits of a project are invested and the proceeds can cover future costs) leads to an inconsistency over the long term (eventually the supposed benefits of any project become larger than the entire GNP). The conventional approach commits an error of double counting by treating the time preference component of the discount rate as if it represented creation of wealth while it really involves only redistribution. The time horizon of the redistribution is limited by the duration of market transactions, especially loans. Thus we recommend a two-step discounting procedure, with the conventional social discount rate for the short term (about 30 years) and the growth rate of the economy for the long term. Data for GNP per capita growth in the US, the UK, France, Germany, Japan and the Soviet Union since the industrial revolution, combined with data for net economic welfare per capita suggest an intergenerational discount rate in the range of 1 to 2%. For practical application the rate at which costs and benefits will grow over time is just as important as the discount rate; only the difference between these two rates matters. For many environmental costs these rates may be close to each other, during the next few generations; this implies that some of the uncertainty in the prediction of rates cancels and one can treat the problem as if the effective rate were close to zero. The consequence for costs such as global warming or nuclear power can be very significant: the valuation can increase by more than an order of magnitude compared to values based on conventional discounting.