Abstract:Uncertain and persistent real interest rates underpin one argument for using a declining term structure of social discount rates in the Expected Net Present Value (ENPV) framework. Despite being controversial, this approach has influenced both the Inter-Agency Working Group on Cost-Benefit Analysis and the UK government's guidelines on discounting. We first clarify the theoretical basis of the ENPV approach. Then, rather than following previous work which used a single series of U.S. Treasury bond returns, we … Show more
“…In every case convergence to the long-run rate happens within 30 years, and typically within less than a decade. This is in contrast to other treatments of fluctuating rates, which assume short term rates are always (or nearly always) positive and predict that the decrease in the discounting rate happens over a much longer timescale, which can be measured in hundreds or thousands of years [11][12][13][14][15][16][17].…”
Section: Resultscontrasting
confidence: 57%
“…Early papers analyzed an extreme case in which the annual real rate is unknown today, but starting tomorrow will be fixed forever at one of a finite number of values [12,13]. More recent papers simulate stochastic interest rate processes out to some horizon, leaving aside the asymptotic behavior of real rates [11,[15][16][17]. The presence of fluctuations can dramatically alter the functional form of the discounting function.…”
For environmental problems such as global warming future costs must be balanced against present costs. This is traditionally done using an exponential function with a constant discount rate, which reduces the present value of future costs. The result is highly sensitive to the choice of discount rate and has generated a major controversy as to the urgency for immediate action. We study analytically several standard interest rate models from finance and compare their properties to empirical data. From historical time series for nominal interest rates and inflation covering 14 countries over hundreds of years, we find that extended periods of negative real interest rates are common, occurring in many epochs in all countries. This leads us to choose the Ornstein-Uhlenbeck model, in which real short run interest rates fluctuate stochastically and can become negative, even if they revert to a positive mean value. We solve the model in closed form and prove that the long-run discount rate is always less than the mean; indeed it can be zero or even negative, despite the fact that the mean short term interest rate is positive. We fit the parameters of the model to the data, and find that nine of the countries have positive long run discount rates while five have negative long-run discount rates. Even if one rejects the countries where hyperinflation has occurred, our results support the low discounting rate used in the Stern report over higher rates advocated by others.arXiv:1311.4068v1 [q-fin.ST]
“…In every case convergence to the long-run rate happens within 30 years, and typically within less than a decade. This is in contrast to other treatments of fluctuating rates, which assume short term rates are always (or nearly always) positive and predict that the decrease in the discounting rate happens over a much longer timescale, which can be measured in hundreds or thousands of years [11][12][13][14][15][16][17].…”
Section: Resultscontrasting
confidence: 57%
“…Early papers analyzed an extreme case in which the annual real rate is unknown today, but starting tomorrow will be fixed forever at one of a finite number of values [12,13]. More recent papers simulate stochastic interest rate processes out to some horizon, leaving aside the asymptotic behavior of real rates [11,[15][16][17]. The presence of fluctuations can dramatically alter the functional form of the discounting function.…”
For environmental problems such as global warming future costs must be balanced against present costs. This is traditionally done using an exponential function with a constant discount rate, which reduces the present value of future costs. The result is highly sensitive to the choice of discount rate and has generated a major controversy as to the urgency for immediate action. We study analytically several standard interest rate models from finance and compare their properties to empirical data. From historical time series for nominal interest rates and inflation covering 14 countries over hundreds of years, we find that extended periods of negative real interest rates are common, occurring in many epochs in all countries. This leads us to choose the Ornstein-Uhlenbeck model, in which real short run interest rates fluctuate stochastically and can become negative, even if they revert to a positive mean value. We solve the model in closed form and prove that the long-run discount rate is always less than the mean; indeed it can be zero or even negative, despite the fact that the mean short term interest rate is positive. We fit the parameters of the model to the data, and find that nine of the countries have positive long run discount rates while five have negative long-run discount rates. Even if one rejects the countries where hyperinflation has occurred, our results support the low discounting rate used in the Stern report over higher rates advocated by others.arXiv:1311.4068v1 [q-fin.ST]
“…21 Writing in "policy forum" for Science, Arrow et al (2013) compare a constant 4% p.a. to the DDR schedules in Newell and Pizer (2003), Groom et al (2007), and Freeman et al (2015). Arrow and the 12 other notable scholars state: "In these studies, estimates of the social cost of carbon are increased by as much as two-to threefold by using a DDR, compared with using a constant discount rate of 4%, the historic mean return on U.S. Treasury bonds" (p.350).…”
Section: Conclusion and Policy Implicationsmentioning
confidence: 99%
“…Among other models, Groom et al (2007) allow for time-dependent parameters by modeling an AR(1) process with an AR(p) coefficient. Subsequently, Freeman et al (2015) use a more complete inflation history to model the process driving the CPI separately from that generating the nominal interest rate. Notes: *** p<0.01, ** p<0.05, * p<0.1.…”
Section: Conclusion and Policy Implicationsmentioning
Standard-Nutzungsbedingungen:Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden.Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen.Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. We examine Singapore's fairly homogeneous private-housing market and show that new apartments on historical multi-century leases trade at a non-zero discount relative to property owned in perpetuity. Descriptive regressions indicate that new apartments with 825 to 986 years of tenure remaining are priced 4 to 6% below new apartments under perpetual ownership contracts that are otherwise comparable. We consider an empirical model in which asset value is decomposed into the utility of housing services and a second factor that shifts with asset tenure and the discount rate schedule. Exploiting the supply of new property with tenure ranging from multiple decades to multiple centuries, we estimate the discount rate schedule, restricting it to vary smoothly over time through alternative parametric forms. Across different specifications and subsamples, we estimate discount rates that decline over time and, accounting for the observed price differences, are of the order of 0.5% p.a. by year 400-500. The finding that households making sizable transactions do not entirely discount benefits accruing many centuries from today is new to the empirical literature on discounting and, with the appropriate risk adjustment, of relevance to evaluating climate-change investments.
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JEL Classification:D61, G12, H43, Q51, Q54, R32
“…They suggest that a state space model performs better than either a random walk or mean-reverting model. Freeman et al (2013) offer several improvements to the data series and specification used by Newell and Pizer (2003) and Groom et al (2007). Figure 3 uses the results from the preferred specification in each paper to simulate the path of forward rates for the US for 400 years.…”
We ask whether the US government should replace its current discounting practices with a declining discount rate schedule, as the United Kingdom and France have done, or continue to discount the future at a constant exponential rate. We present the theoretical basis for a declining discount rate (DDR) schedule, but focus on how, in practice, a DDR could be estimated for use by policy analysts. We discuss the empirical approaches in the literature and review how the United Kingdom and France estimated their DDR schedules. We conclude with advice on how the United States might proceed to consider modifying its current discounting practices.
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