1932

Abstract

Most Western countries use a single discount rate to evaluate public investments and policies. This ignores the differential cost of risk, in a world where most risk markets exhibit surprisingly large prices of risk. The current discounting guidelines generate a misallocation of capital that entails a large welfare cost. We claim that the well-established asset pricing literature provides a strong normative justification in favor of risk-adjusting discount rates. More specifically, project-specific discount rates should be increasing in the income elasticity of the project's net benefit. This will favor projects whose net benefit materializes preferentially in low-income states, thereby recognizing their insurance benefit ex ante. The intuition is simple, the welfare benefit of the reform is large, and the methodology only requires evaluators to estimate an income elasticity on top of what is required in the current approach. It is time to fix our public discounting systems.

Loading

Article metrics loading...

/content/journals/10.1146/annurev-financial-102921-111749
2023-11-01
2024-06-25
Loading full text...

Full text loading...

/deliver/fulltext/financial/15/1/annurev-financial-102921-111749.html?itemId=/content/journals/10.1146/annurev-financial-102921-111749&mimeType=html&fmt=ahah

Literature Cited

  1. Arrow K, Cropper M, Gollier C, Groom B, Heal G et al. 2013. Determining benefits and costs for future generations. Science 341:349–50
    [Google Scholar]
  2. Arrow K, Lind R. 1970. Uncertainty and the evaluation of public investment decisions. Am. Econ. Rev. 60:364–78
    [Google Scholar]
  3. Bansal R, Kiku D, Yaron A. 2016. Risks for the long run: estimation with time aggregation. J. Monet. Econ. 82:52–69
    [Google Scholar]
  4. Bansal R, Yaron A. 2004. Risks for the long run: a potential resolution of asset pricing puzzles. J. Finance 59:1481–509
    [Google Scholar]
  5. Barro R. 2006. Rare disasters and asset markets in the twentieth century. J. Finance 121:823–66
    [Google Scholar]
  6. Bauer MD, Rudebusch GD. 2021. The rising cost of climate change: evidence from the bond market. Rev. Econ. Stat. 2021. https://doi.org/10.1162/rest_a_01109
    [Google Scholar]
  7. Baumstark L, Gollier C. 2014. The relevance and the limits of the Arrow-Lind theorem. J. Nat. Resourc. Policy Res. 6:45–49
    [Google Scholar]
  8. Bazelon C, Smetters K. 1999. Discounting inside the Washington D.C. beltway. J. Econ. Perspect. 13:213–28
    [Google Scholar]
  9. Bouttes JP, Gollier C, Allemand ALM, Pommeret A, Preud'homme E 2021. Contre-expertise de l'évaluation socioéconomique du projet de cigeo. Tech. Rep. Secrétariat Général pour l'Investissement Paris:
    [Google Scholar]
  10. Breeden D. 1979. An intertemporal asset pricing model with stochastic consumption and investment opportunities. J. Financ. Econ. 7:265–96
    [Google Scholar]
  11. Carleton T, Greenstone M. 2021. Updating the United States government's social cost of carbon. Work. Pap. 2021-04 Energy Policy Inst. Univ. Chicago:
    [Google Scholar]
  12. Cherbonnier F, Gollier C. 2021. Risk-adjusted social discount rates. Energy J. 43:419–41
    [Google Scholar]
  13. Cherbonnier F, Gollier C, Pommeret A. 2022. Stress discounting. Work. Pap. Toulouse Sch. Econ. Fr.:
    [Google Scholar]
  14. Daniel KD, Litterman RB, Wagner G. 2019. Declining CO2 price paths. PNAS 116:4220886–91
    [Google Scholar]
  15. Dietz S, Gollier C, Kessler L. 2018. The climate beta. J. Environ. Econ. Manag. 87:258–74
    [Google Scholar]
  16. Drupp MA, Freeman MC, Groom B, Nesje F. 2018. Discounting disentangled. Am. Econ. J. Econ. Policy 10:4109–34
    [Google Scholar]
  17. Environ. Prot. Agency (EPA) 2021. Standards of performance for new, reconstructed, and modified sources and emissions guidelines for existing sources: oil and natural gas sector climate review. Federal Register, Vol. 86:, No. 217 Nov. 15
    [Google Scholar]
  18. Epstein L, Farhi E, Strzalecki T. 2014. How much would you pay to resolve long-run risk?. Am. Econ. Rev. 104:2680–97
    [Google Scholar]
  19. Gollier C. 2008. Discounting with fat-tailed economic growth. J. Risk Uncertain. 37:171–86
    [Google Scholar]
  20. Gollier C. 2012. Pricing the Planet's Future: The Economics of Discounting in an Uncertain World Princeton, NJ: Princeton Univ. Press
    [Google Scholar]
  21. Gollier C. 2016. Evaluation of long-dated assets: the role of parameter uncertainty. J. Monet. Econ. 84:66–83
    [Google Scholar]
  22. Gollier C. 2021. The welfare cost of ignoring the beta. Disc. Pap. DP16007 Cent. Econ. Policy Res. London:
    [Google Scholar]
  23. Gollier C, Hammitt JK. 2014. The long-run discount rate controversy. Annu. Rev. Resourc. Econ. 6:273–95
    [Google Scholar]
  24. Gollier C, van der Ploeg R, Zheng J. 2022. The Discounting Premium Puzzle: Survey Evidence from Professional Economists Oxford, UK: Oxford Univ.
    [Google Scholar]
  25. Hagen K, Bernstein S, Bye B, Hltkrantz L, Nyborg K et al. 2012. Cost-benefit analysis. Tech. Rep. Offic. Nor. Rep. NOU 2012 16
    [Google Scholar]
  26. Kimball M. 1990. Precautionary saving in the small and in the large. Econometrica 58:53–73
    [Google Scholar]
  27. Krueger P, Landier A, Thesmar D. 2015. The WACC fallacy: the real effects of using a unique discount rate. J. Finance 70:1253–85
    [Google Scholar]
  28. Lemoine D. 2021. The climate risk premium: How uncertainty affects the social cost of carbon. J. Assoc. Environ. Resour. Econ. 8:127–57
    [Google Scholar]
  29. Lucas D. 2012. Valuation of government policies and projects. Annu. Rev. Financ. Econ. 4:39–58
    [Google Scholar]
  30. Lucas D. 2014a. Evaluating the cost of government credit support: the OECD context. Econ. Policy 29:79553–97
    [Google Scholar]
  31. Lucas D. 2014b. Rebutting Arrow and Lind: why governments should use market rates for discounting. J. Nat. Resourc. Policy Res. 6:85–91
    [Google Scholar]
  32. Lucas D, Montesinos J. 2021. A fair value approach to valuing public infrastructure projects and the risk transfer in public-private partnerships. Economic Analysis and Infrastructure Investment ed. EL Glaeser, JM Poterbapp. 369–402 Chicago: Univ. Chicago Press
    [Google Scholar]
  33. Lucas R. 1978. Asset prices in an exchange economy. Econometrica 46:1429–46
    [Google Scholar]
  34. Martin I. 2013. Consumption-based asset pricing with higher cumulants. Rev. Econ. Stud. 80:745–73
    [Google Scholar]
  35. Mehra R, Prescott EC. 1985. The equity premium: a puzzle. J. Monet. Econ. 15:145–61
    [Google Scholar]
  36. Newell RG, Pizer WA, Prest BC. 2022. A discounting rule for the social cost of carbon. J. Assoc. Environ. Resour. Econ. 9:51017–46
    [Google Scholar]
  37. Nordhaus W. 2013. The Climate Casino: Risk, Uncertainty and the Economics for a Warming World New Haven, CT: Yale Univ. Press
    [Google Scholar]
  38. Off. Manag. Budg 2003. To the heads of executive department establishments, subject: regulatory analysis Circular A-4, Sept. 17 Exec. Off. Pres., Off. Manag. Budg. Washington, DC:
    [Google Scholar]
  39. Quinet E. 2013. L'évaluation socioéconomique des investissements publics. Tech. Rep. Comm. Gén. Stratég. Prospect. Paris:
    [Google Scholar]
  40. Rennert K, Errickson F, Prest BC, Rennels L, Newell RG et al. 2022a. Comprehensive evidence implies a higher social cost of CO2. Nature 610:687–92
    [Google Scholar]
  41. Rennert K, Prest BC, Pizer WA, Newell RG, Anthoff D et al. 2022b. The social cost of carbon: advances in long-term probabilistic projections of population, GDP, emissions, and discount rates. Brookings Pap. Econ. Act. 2021:2223–305
    [Google Scholar]
  42. Rietz T. 1988. The equity risk premium: a solution. J. Monet. Econ. 22:117–31
    [Google Scholar]
  43. Rijksoverheid. 2020. Rapport werkgroep discontovoet 2020. Tech. Rep. Dutch Ministerie van Financien Den Haag, Neth:.
    [Google Scholar]
  44. Rubinstein M. 1976. The valuation of uncertain income streams and the pricing of options. Bell J. Econ. 7:407–25
    [Google Scholar]
  45. Sandsmark M, Vennemo H. 2007. A portfolio approach to climate investments: CAPM and endogenous risk. Environ. Resour. Econ. 37:681–95
    [Google Scholar]
  46. Segal U, Spivak A. 1990. First order versus second order risk aversion. J. Econ. Theory 51:111–25
    [Google Scholar]
  47. Stern N, Stiglitz J. 2021. The social cost of carbon, risk, distribution, market failures: an alternative approach NBER Work. Pap. 28472
    [Google Scholar]
  48. Sunstein C. 2014. On not revisiting official discount rates: institutional inertia and the social cost of carbon. Am. Econ. Rev. 104:547–51
    [Google Scholar]
  49. UK Treasury 2020. Green book: central government guidance on appraisal and evaluation. Tech. Rep. UK Treasury London:
    [Google Scholar]
  50. Weil P. 1989. The equity premium puzzle and the risk-free rate puzzle. J. Monet. Econ. 24:401–21
    [Google Scholar]
  51. Weitzman M. 2001. Gamma discounting. Am. Econ. Rev. 91:260–71
    [Google Scholar]
  52. Weitzman M. 2007. Subjective expectations and asset-return puzzles. Am. Econ. Rev. 97:1102–30
    [Google Scholar]
  53. Weitzman M. 2009. On modeling and interpreting the economics of catastrophic climate change. Rev. Econ. Stat. 91:1–19
    [Google Scholar]
/content/journals/10.1146/annurev-financial-102921-111749
Loading
/content/journals/10.1146/annurev-financial-102921-111749
Loading

Data & Media loading...

Supplementary Data

  • Article Type: Review Article
This is a required field
Please enter a valid email address
Approval was a Success
Invalid data
An Error Occurred
Approval was partially successful, following selected items could not be processed due to error