Discounting the distant future: How much does model selection affect the certainty equivalent rate?

Abstract

Evaluating investments with long-term consequences using discount rates that decline with the time horizon, (Declining Discount Rates or DDRs) means that future welfare changes are of greater consequence in present value terms. Recent work in this area has turned towards operationalising the theory and establishing a schedule of DDRs for use in cost benefit analysis. Using US data we make the following points concerning this transition: i) model selection has important implications for operationalising a theory of DDRs that depends upon uncertainty; ii) misspecification testing naturally leads to employing models that account for changes in the interest rate generating mechanism. Lastly, we provide an analysis of the policy implications of DDRs in the context of climate change for the US and show that the use of a state space model can increase valuations by 150% compared to conventional constant discounting.JEL classification: C13, C53, Q2, Q4

Declining discount rates and the Fisher Effect: Inflated past, discounted future?

“…Yet, these results were shown to be highly sensitive to the time-series model used to characterize interest rate uncertainty. Subsequent work by Groom, Koundouri, Panopoulou and Pantelidis [25] (henceforth GKPP) showed that more flexible characterizations of interest rate uncertainty lead to a schedule of DDRs that raises the SCC yet further to $14.4/tC. Similar results have been found in many different countries and also when a global perspective is taken [28,22].…”

“…Qualitatively speaking, Figures 3 and 4 show that persistence again declines towards the more recent windows of data containing a greater proportion of the post-1949 real interest rate series. More importantly, when the data is smoothed 10 See GKPP for the US and [24] for the UK. 11 The ADF test contains the lagged difference terms appropriate for the AR(4) model.…”

“…Table 4 presents the stability tests for the parameters in the co-integrating regression. 24 A p-value of 0.20 suggests significance at > 0.20 level. Overall, our findings suggest that the co-integrating relationship between the US inflation and the nominal interest rate is stable.…”

“…This lack of consensus turns out to be important since evaluation of intergenerational projects is very sensitive to the discount rates deployed. Indeed, the range of policy prescriptions arising from different approaches to estimating the DDR schedule is comparable to that arising from the thorny normative-positive debate that characterized the aftermath of the Stern Review [43,25,14].…”

“…[29, p98. ] 5 Our empirical contributions flow from an inspection of the time-series of bond yields used by N&P. Their data have been particularly important as a testing ground for empirical methods for discounting in several other contributions [25,22,28]. The main irregularity is that the data used by N&P, i.e.…”