Academic journal article Contemporary Economic Policy

Climate Change and Overlapping Generations

Academic journal article Contemporary Economic Policy

Climate Change and Overlapping Generations

Article excerpt


The role of discounting in evaluating policies with short-run costs and long-run benefits is a central issue in the economics of climate change. Cline (1992) uses a real discount rate of 1.5 percent/year to establish that greenhouse gas emissions reductions of 40% relative to 1990 levels are economically justified for risk averse decision makers. In contrast, Nordhaus (1994) uses an optimal growth model with endogenously determined, time-varying discount rates of 4 to 6 percent/year to show that only modest steps towards emissions abatement are warranted given present understanding of climate change and its potential economic effects. Differences in discounting assumptions explain the disparity between these studies. Chapman et al. (1995) find that a simplified version of the Nordhaus model prescribes much more aggressive policies when it is parameterized to attach more weight to the future.

The theoretical literature suggests that at least three sets of factors are relevant in determining the appropriate discount rates to use in cost-benefit analysis (Lind, 1982): (i) the impacts of distortionary taxes and transaction costs in capital markets (Kolb and Scheraga, 1990); (ii) uncertainty concerning future costs and benefits (Wilson, 1982); and (iii) social preferences concerning the distribution of welfare between present and future generations. While each of these issues raises important challenges for empirical research, the treatment of future generations is perhaps the most interesting and difficult from a normative perspective. The present analysis therefore focuses on this aspect of the discounting questions.

Critics allege that discounting is inherently unfair to future generations (Parfit, 1983). However, economists point out that discounting procedures are essential to the pursuit of Pareto efficiency through cost-benefit analysis. In a world of perfect foresight and efficient capital markets, the social discount rate is appropriately set equal to the market rate of interest, which reflects individuals' marginal willingness to exchange present and future consumption. Economists recognize, however, that Pareto efficiency is a weak normative criterion that does not itself ensure the fair treatment of future generations. Solow (1974), for example, notes that:

[E]ven well-functioning competitive markets may fail to allocate resources properly over time...because the future [holds] no endowment of its own...The intergenerational distribution of income or welfare depends on the provision that each generation makes for its successors. The choice of a social discount rate is, in effect, a policy decision about that inter-generational distribution.

Building on this insight, Howarth and Norgaard (1995) show that identifying an optimal intertemporal path involves a two-step procedure: First, achieving a desirable distribution of welfare between generations involves specifying the capital endowments of future generations. Second, one then can use cost-benefit analysis to improve the efficiency of resource allocation given the discount rates and shadow prices determined in step one.

In fact, Nordhaus (1994), implicitly takes such an approach. He identifies an optimal path for capital investment and greenhouse gas emissions by maximizing a social welfare function where the future utility of an infinitely-lived, representative agent is discounted at a rate of 3 percent/year. In optimal growth models, savings and investment are determined endogenously so as to define the rate at which future costs and benefits should be discounted in cost-benefit analysis. Under the base case assumptions of Nordhaus' model, monetary discount rates (i.e., the social discount rates appropriately employed in cost-benefit analysis) fall from 6 percent/year in the present to 4 percent/year by the late 21st century.

Despite their widespread application, using utility discounting and representative agent models in climate change policy analysis begs two types of questions. …

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