To Accurately Estimate a Policy’s Future Benefits and Costs, Consider the Consumer

Climate change will have far-reaching consequences for society—which is why accurately estimating the future costs and benefits of climate policies is particularly important. A new issue brief from Resources for the Future (RFF) takes a closer look at how the value of these potential costs and benefits is calculated, finding that a focus on the profitability of an investment, rather than a consumer’s return on that investment, can dramatically undervalue the benefits of emissions reductions policies.

For nearly 20 years, the federal government has used two “discount rates”—the rate used to assess how much a policy’s future effects are worth—to analyze the long-term benefits and costs of a climate policy. One is based on an investment’s pre-tax profitability—roughly 7 percent. The other is based on a consumer’s after-tax earnings on an investment—roughly 3 percent.  This approach followed an evolving debate regarding the best discount rate to use to for cost-benefit analysis, with some arguing in favor of the consumer approach while others call for an investment-focused approach.

These different discount rates can result in very different outcomes, particularly for policies that have effects far into the future. Take, for example, the consequences from carbon dioxide emissions—the calculated economic damages are six to nine times higher using the consumer’s discount rate (3%) than the investment’s discount rate (7%).

“The differences based on current discounting guidelines are substantial and could determine a policy’s success—but it shouldn’t be this way,” coauthor and RFF Senior Fellow Billy Pizer said. “Our approach, which follows standard economics, argues for valuing impacts on investment and consumption differently—but not by messing with discount rates, which should always focus on the consumer’s perspective.”

In particular, Pizer shows how effects on investment must first be adjusted using the “shadow price” of capital. This shadow price reflects the benefit to society of the taxes on investment returns that are not directly seen by consumers.  Costs and benefits adjusted in this way can then be valued over time based on the consumer’s rate of time preference. When it is unclear whether policies affect investment or consumption, sensitivity analyses that alternately scale costs and benefits by the shadow price can help accurately bound a policy’s influence.

“Focusing on a policy’s future effects on the consumer, while also taking into account the different consequences of capital and consumption effects, can help ensure that we conduct cost-benefit analysis fairly and consistently,” Pizer said. “These discount rates are incredibly important to policy analysis—it’s imperative we get this right.”

For more, read the issue brief, “Discounting for Public Benefit-Cost Analysis,” by RFF Senior Fellow Billy Pizer and Clarkson Professor Qingran Li.