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Lawrence H. Goulder and Robert N. Stavins

Decisions made today usually haveimpacts both now and in the future.But in carrying out policy evaluations

to help decision-makers, economic analyststypically discount future impacts. In theenvironmental realm, many of the futureimpacts are benefits from policy-inducedimprovements. Thus, in the environmental-policy context, future benefits (as well ascosts) are often discounted.

This is controversial, partly because dis-counting can seem to give insufficient weightto future benefits and thus to the well-beingof future generations. But does it actuallyshortchange the future? As economists, wehave often encountered scepticism about dis-counting, particularly from non-economists.Some of this scepticism seems valid, yet somereflects misconceptions about the natureand purpose of discounting. By examining

here how discounting affects the evaluationof environmental policies, we hope to clarifythis concept.

It helps to begin by considering the use of discounting in private investments. Here,the rationale stems from the fact that capitalis productive — money earns interest. Con-sider a company deciding whether to invest$1 million in the purchase of a copper mine,and suppose that the most profitable strategyinvolves extracting the available copper three years from now, yielding revenues (netof extraction costs) of $1,150,000. Wouldinvesting in this mine make sense? Assumethat the company has the alternative ofputting the $1 million in the bank at 5%annual interest. Then, on a purely financialbasis, the company would do better with the bank, as after three years it will have$1,157,625 ($1,000,0002(1.05)3), com-pared with only $1,150,000 if it invests in the mine.

Future returnsWe compared these alternatives by com-pounding to the future the up-front cost ofthe project. It is mathematically equivalentto compare the options by discounting tothe present the future revenues or benefitsfrom the mine. Discounting offers a quickway to check whether the return on a pro-ject is greater or less than the interest rate bytaking future revenues and translating theminto present units, using the ‘alternative rateof return’ (the bank’s rate of interest in ourexample) as the discount rate. So the dis-counted revenue in this case is $1,150,000divided by (1.05)3, or $993,413 — less thanthe cost of the investment. Thus, the projectwould not earn as much as the alternative ofputting money in the bank. If the discountedrevenue exceeded the cost of the project,then the project would yield a higher returnthan the bank, and the company would bebetter off investing in the mine.

This simple example suggests a generalformula to determine whether an invest-ment offers a return that is greater or lessthan the alternative of putting money in thebank. Suppose a project involves benefits(revenues) and costs over a time span fromthe present (time 0) to T years from now. LetBt and Ct refer, respectively, to the benefit andcost t years from now, and let r represent theannual rate of return on a standard invest-ment. The present value of the net benefit(PVNB) is given by

T

PVNB4S(Bt1Ct)/(1&r)t

t40

If this value is positive, the project will yield

a return that is higher than the marketinterest rate.

Discounting translates future sums ofmoney into equivalent current sums; itundoes the effects of compound interest. It isnot aimed at accounting for inflation, as evenif there were no inflation it would still be necessary to discount future revenues toaccount for the fact that a dollar today trans-lates (through interest) into more dollars inthe future.

Sums for societyCan the same kind of thinking be applied toinvestments made by the public sector forthe benefit of society? Consider the follow-ing hypothetical public-sector investment: apotential climate policy. Our purpose is toconvey key issues in the starkest terms, so wewill intentionally oversimplify some aspectsof what follows. Suppose that a policy, ifintroduced today and maintained, wouldavoid significant damage to the environ-ment and human welfare 100 years fromnow. The ‘return on investment’ is theavoidance of future damage to the environ-ment and to people’s well-being. Supposethat this policy costs $4 billion to imple-ment, and that this cost is borne in itsentirety today. Suppose also that the benefi-cial impacts — avoided damages to the envi-ronment — will be worth $800 billion topeople alive 100 years from now. Should thepolicy be implemented?

The answer will depend, of course, on theevaluation criteria used. Consider first thecriterion of whether the winners have thepotential to compensate the losers and still beno worse off. For this condition to be met, thebenefit to the winners, after being translatedto equivalent dollars, needs to be larger thanthe losses of the losers. After compensationfrom winners to losers, the policy would yieldwhat economists call a ‘Pareto improvement’:some individuals would be better off, and noindividual would be worse off.

Are the benefits great enough that thewinners could potentially compensate thelosers and still be no worse off? Here, dis-counting is helpful. If, over the next 100years, the average rate of interest on ordinaryinvestments is 5%, a gain of $800 billion topeople 100 years from now is equivalent to$6.08 billion today. (Equivalently, $6.08 bil-lion today, compounded at an annual inter-est rate of 5%, will become $800 billion in

An eye on the futureconcepts

NATURE | VOL 419 | 17 OCTOBER 2002 | www.nature.com/nature 673

DiscountingHow economists’ controversialpractice of discounting really affects the evaluation ofenvironmental policies.

Laying a golden egg? Discounting allows potentialinvestors to weigh up their potential returns.

© 2002 Nature Publishing Group

100 years.) The project satisfies the principleof potential compensation if it costs the current generation less than $6.08 billion.

Because the up-front cost of $4 billion isindeed less than this figure, the benefit tofuture generations is more than enough tooffset the cost to the current one. More gen-erally, a positive PVNB means that the policyhas the potential to yield a Pareto improve-ment. More realistic policies involve costsand benefits that occur at all points in time.For these policies, discounting serves thesame purpose, as we convert costs and benefits from various periods into theirequivalents at a given time (such as the present, for example).

Applying a discount rate does not meangiving less weight to the welfare of futuregenerations. Rather, the process simply con-verts the (full) values of the impacts thatoccur at different points of time into common units. In our example, the full ben-efit to future generations is translated into acurrent monetary sum, which then allows usto compare this benefit with the full cost tothe present generation.

Winners and losersEven if one accepts the idea of discountingas a mechanism to translate impacts intoequivalent monetary units, one might beuneasy about PVNB analysis, which is basedon the potential Pareto improvement (PPI)criterion — whether the winners from agiven policy could compensate the losersand still be better off. If a policy’s benefitsexceed its costs, and compensation is intro-duced so that no one is worse off, then theattractiveness of the policy seems clear. Butif compensation is not actually made, theappeal seems considerably weaker.

In our climate-policy example, discountedbenefits to future generations will exceed theloss to the current generation, so the poten-tial exists for a Pareto improvement — thePPI criterion is met. But if future generationsdo not actually compensate the present one,is it still appropriate to enact the policy? Perhaps so, but many would argue that ifactual compensation cannot be made, a positive PVNB has less merit as an evaluationcriterion.

Suppose a proposed climate policy failsthe PPI test — the future benefits are notlarge enough to offset current costs. Do current generations nevertheless have anobligation to undertake the policy? Theymight. The PPI criterion deserves to be given

weight, but in almost all policy evaluations— especially when compensation is notactually carried out — it is important to consider other evaluation criteria, as thereare bound to be some cases in which there arecompelling reasons for adopting a policyeven when the PPI criterion is not satisfied,or for rejecting a policy even when it is.

Should a lower discount rate be used toincorporate considerations of intergenera-tional equity more fully in the PVNB calcula-tion? Suppose that, when the market interestrate is used for discounting, a policy thatwould benefit future generations fails to generate a positive PVNB. Using a lower discount rate would give greater weight tofuture benefits (and costs), possibly makingthe PVNB positive. Such adjustments areproblematic, however: they blur the distinc-tion between the PPI (efficiency) criterionand other legitimate policy-evaluation criteria, such as distributional (in this case,intergenerational) equity. In evaluating policies, it seems better to use the marketinterest rate so that the PVNB calculationprovides a meaningful indication of whetherthe PPI criterion is satisfied, while at thesame time judging intergenerational fairnessby direct examination.

Even if one accepts the use of the PPI criterion and discounting in principle, esti-mates of PVNB are necessarily imprecise.There is uncertainty about the denominator— the discount rate. Theoretically, thisshould reflect the market interest rate but, ofcourse, future market rates are impossible topredict. There is also considerable uncertain-ty about the elements in the numerator — thebenefits and costs that current and futuregenerations will experience from a policy thatis introduced today. This uncertainty isderived both from scientific uncertaintyabout the biophysical impacts of policies andfrom uncertainty about future generations’tastes and preferences — how much they willvalue the biophysical impacts.

Much scepticism about discounting and,more broadly, the use of benefit–cost analy-sis, is connected to these uncertainties. Consider the difficulties of ascertaining, forexample, the benefits that future generationswould enjoy from a regulation that protectscertain endangered species. Some of the gainto future generations might come in the formof medical products (such as serums or vac-cines) derived from the protected species, but such future impacts are impossible topredict. Moreover, benefits reflect the value

that future generations will attach to the pro-tected species — the enjoyment of observingthem in the wild or just knowing of their existence. But how can we predict future gen-erations’ values? Economists and other socialscientists try to infer them through surveys(such as the contingent valuation method)and by inferring preferences from individu-als’ behaviour. But these approaches are farfrom perfect, and at best they indicate onlythe values or tastes of people alive today.

The uncertainties are substantial andunavoidable. They do not invalidate the use ofdiscounting or benefit–cost analysis, but theydo oblige analysts to acknowledge them intheir policy evaluations. It is crucial to evalu-ate policies using a range of values for dis-count rates and for future benefits and costs.We should have less confidence in a project forwhich the sign of the PVNB is highly sensitiveto the discount rate or to small changes in projected future benefits and costs, comparedwith a project with a PVNB that is not verysensitive to these elements.

The discounting debateThe application of discounting to environ-mental-policy evaluation is controversial,partly because of misunderstanding outsidethe economics community of what dis-counting actually does, which is to translatethe values of future impacts into equivalentvalues in today’s monetary units. The PPIcriterion, which provides the rationale fordiscounting and calculation of the PVNB,deserves weight in evaluating environmen-tal policies, although it is also important toconsider other criteria (such as distribu-tional equity), especially when the potentialharm to ‘losers’ is substantial. Moreover, itis crucial to acknowledge any uncertaintiesabout benefits, costs and interest rates.Some may argue that these complicationsinvalidate PVNB calculations, but in ourview such calculations — when carefullyexecuted and thoughtfully interpreted —can provide useful information for makingenvironmental-policy decisions. ■

Lawrence H. Goulder is in the Department ofEconomics and the Institute for InternationalStudies, Stanford University, Stanford, California94305, USA. Robert N. Stavins is at the John F.Kennedy School of Government, Harvard University,79 John F. Kennedy Street, Cambridge,Massachusetts 02138, USA.

FURTHER READINGArrow, K. J. et al. in Climate Change 1995: Economicand Social Dimensions of Climate Change (eds Bruce,J. P. et al.) 125–144 (Cambridge Univ. Press, 1996).Arrow, K. J. et al. Science 272, 221–222 (1996).Fullerton, D. & Stavins, R. Nature 395, 433–434 (1998).Portney, P. R. & Weyant, J. P. Discounting andIntergenerational Equity (Resources for the Future,Washington DC, 1999).Weitzman, M. L. J. Environ. Econ. Management 36,201–208 (1998).

concepts

674 NATURE | VOL 419 | 17 OCTOBER 2002 | www.nature.com/nature

Uncertainty is unavoidable. This does notinvalidate the use of discounting or

benefit–cost analysis, but it does oblige analyststo acknowledge it in their policy evaluations.

© 2002 Nature Publishing Group