What is the appropriate discount rate to use in assessing climate change mitigation policies?

The correct answer, in my view, is that the appropriate discount rate depends on the kind of policy that is being considered. If that answer seems odd to you then there is a good chance you have not yet read Mark Harrison’s paper entitled ‘Addressing Wellbeing in the Longer-Term: a Review of Intergenerational Equity and Discount Rates in Climate Change Analysis’. The paper was published last year in Measuring and Promoting Wellbeing, a collection of essays in honour of Ian Castles (an Australian who deserved to be honoured highly for his work on measurement of wellbeing).

The kind of policy that was evaluated in the famous cost benefit study by Nicholas Stern (and the subsequent study by Ross Garnaut) involves imposing some kind of tax (perhaps via a cap and trade mechanism) on carbon emissions in order to improve the well-being of future generations. Stern and Garnaut assume that economic growth will continue even in the absence of policies to mitigate carbon emissions and global warming, resulting in much higher average income levels in future (3.6 times higher 100 years from now in Stern’s projection).

Photo by Robin Ellis. Some rights reserved.

The carbon tax that this kind of modelling exercise suggests to be appropriate is highly sensitive to the discount rate that is used to determine the present value of mitigation efforts. The use of a low discount rate suggests that strong immediate action is warranted to mitigate climate change, whereas a higher discount rate suggests that the most appropriate course of action is to begin with a very low carbon tax and raise it gradually. In an illustrative example Harrison shows that with a discount rate of 1.35%, as assumed by Stern, the optimal current carbon tax is $78.48 per tonne, whereas with a discount rate of 6% it is only $0.88.

The discount rates used by Stern and Garnaut are an application of the social welfare function approach. Social welfare functions necessarily embody ethical judgements, even though such judgements are hidden beneath empirical facts in some versions of the, so called, Ramsey formula used by climate change modellers. Opinions differ on what ethical judgements are appropriate and discount rates can vary widely depending on what assumptions are made. Harrison demonstrates that the Ramsey formula gives estimates of a risk free discount rate ranging from 0.24% to 11% under the range of parameter values used in a variety of studies over the past decade.

At this point some readers will probably be throwing up, while others will be wondering what discount rates would be consistent with ethical judgements that they would be prepared to endorse. One way to consider whether you would be prepared to pay a carbon tax costing you $x per month in order to make your great grandchildren better off is to ask yourself whether you would prefer to make a financial investment of the same amount each month into some kind of trust for their benefit. The answer you obtain by considering opportunity costs in this way is equivalent to discounting the real money value of the benefits of climate change mitigation by the rate of return that you could expect to obtain on the alternative investment – presumably higher than the average real long term bond rate over the past 20 years or so.

One possible objection to this approach is that the rate of return on alternative investments will incorporate an element of compensation for risk, which is not appropriate in considering public investments such as climate change mitigation. The response which Mark Harrison provides is to point out that investment in climate change mitigation are far from risk free. There is a great deal of uncertainty about future costs and benefits of such policies. Most obviously, if you decide to vote for the carbon tax option you have no guarantee that people in other countries will pull their weight by imposing similar taxes on their citizens.

Some of you will by now be thinking that the cost benefit framework outlined above must be a load of garbage because you remain concerned about climate change, even though you would prefer to invest money for the benefit of your great grandchildren rather than to pay a carbon tax. If you are concerned about climate change, you are unlikely to be concerned that your great grandchildren will suffer losses that you could compensate for by increasing your savings rate by a small amount. The chances are that you (like me) will be concerned about the remote possibility that your great grandchildren might suffer from having to live with potentially catastrophic climate change outcomes.

Mark Harrison points out that by explicitly accounting for risk, rather than assuming it away, we can distinguish between policies that reduce risk and those that don’t. Mitigation policies that are potentially effective in averting disasters should be subjected to a discount rate that is below the risk-free rate because they pay off at a time when returns on other assets are low or negative, and when willingness to pay is great.

So, my conclusion:

•  the most appropriate discount rate to use to evaluate policies such as carbon taxes is the long-term average of real market rates of return on capital; and  
• the most appropriate discount rate to use to evaluate policies directed more specifically toward averting disasters - such as public investment in research to develop low-cost ways to removing greenhouse gases from the atmosphere - should be lower than the long-term average of real government bond rates.

In the unlikely event that we are faced with something close to the worst case climate scenario, our current policies to encourage adoption of inefficient alternative energy options are unlikely to avert catastrophe.  If the objective is to reduce the risk of catastrophe we should be using an evaluation methodology that helps us to choose the lowest cost method of achieving that objective.

Postscript:

There seems to be increasing awareness that we should be asking how we can insure against the worst climate change outcomes at lowest cost. Martin Wolf has published a relevant article entitled ‘Climate actions hould be seen as insurance’, in which he discusses Climate Shock, a new book by Gernot Wagner of the Environmental Defense Fund and Martin Weitzman of Harvard University. There has been a fairly favourable review of Climate Shock by William Nordhaus in the New York Review of Books.

I get the impression that the authors of Climate Shock have come to the conclusion that the best form of insurance is to reduce CO2 emissions as rapidly as possible. They rule out engineering solutions directed toward managing solar radiation (probably for good reasons) but it is not clear whether they have considered the potential benefits of research into ways to take greenhouse gases out of the atmosphere.

It is also unclear whether urgent action is justified, given the fact that when global warming resumes it will probably have positive net economic benefits for a few more years. I expect the variance of potential outcomes is not as great over the next decade or so as it is when we look further into the future.

The review article by William Nordhaus offers a solution to the free rider problem in international negotiations in the form of a climate change club  imposing trade sanctions on countries that are perceived to be laggards. That kind of thinking makes me wonder whether the science of climate change might turn out to be less important for a country like Australia than foreign policy and trade considerations. The formation of a climate change club seems a more worrying prospect at the moment than the potential for an increased incidence of droughts and bushfires. 

How does nature connectedness affect happiness?

White sands walk: Jervis Bay, NSW, Australia

How important is a constant intercourse with nature and the contemplation of natural phenomena to the preservation of moral and intellectual health!   Henry David Thoreau, Journal, 6 May 1851.

Thoreau still speaks eloquently for everyone who feels a need to spend time in the natural environment in order to re-charge their emotional batteries. Recognition of the importance of the natural environment to human happiness now seems to be supported by the findings of social research which show that nature connectedness - identifying with and feeling connected to the natural world – is correlated with happiness. The strength of this relationship is similar to that between happiness and personal income, marital status, volunteering, and personality traits such as conscientiousness and agreeableness.

Formal evidence on links between nature connectedness and happiness has only emerged during the last few years. What I write below is based mainly on a meta-analysis by Colin Capaldi, Raelyne Dopko and John Zelenski published in September last year. In order to be included in the meta-analysis, studies had to include at least one explicit, self-report measure of nature connectedness and at least one measure of happiness and report on their relationship. The meta-analysis covered 30 samples, giving a total sample size of 8523. Most samples came from Canada, the U.S. and Europe.

The meta-analysis showed that the strength of the measured relationship between nature connectedness and happiness was influenced by the way these variables were defined and measured. A measure of inclusion of nature in self had a stronger relationship than other measures of connectedness. Vitality was the happiness concept with the strongest relationship to nature connectedness.

The authors note that correlation between nature connectedness and happiness does not necessarily indicate that nature connectedness causes people to be happier. It is possible that causation might run from happiness to nature connectedness or that some third variable might be responsible for the observed correlation.

However, there is fairly clear evidence from another meta-study (by  Diana Bowler et al) that exercise in natural environments promotes greater emotional health benefits – in terms of feelings of energy, and less anxiety, anger, fatigue and sadness - than exercise in an artificial environment. There is also evidence that nature connectedness is positively related with time spend outdoors in contact with nature.

It is possible that some part of the correlation between nature connectedness and happiness is associated with feeling connected. Feeling connected to nature might be similar in that respect to feeling connected with the community. The relationship between nature connectedness and happiness is still evident, however, when other connections (e.g. family and culture) are controlled for.

The authors note that the relationship between nature connectedness and some forms of happiness may be adversely affected, to some extent, by a tendency of people who feel connected to nature to be worried about the future of the environment. Such concerns are more likely to dampen positive emotions than eudaimonic measures of happiness because such people are likely to become engaged in pro-environmental behaviours that make their lives seem more meaningful.

There is evidence that feelings of nature connectedness are stronger in some cultures than others and are influenced by early childhood experiences. That suggests to me that causation runs from nature connectedness to happiness, rather than vice versa.

Is human flourishing inconsistent with living in harmony with nature?

A view of Sydney in 2014

I like many of the ideas in the Ecomodernist Manifesto, but I don’t like the idea of having to choose between making room for nature and living in harmony with nature. Before discussing this issue I will provide some background.

The Manifesto, published in April of this year, has 18 authors of whom the best known are probably Ted Nordhaus and Michael Shellenberger of the Breakthough Institute.

The Ecomodernists begin with the proposition that the earth has entered into a new geological epoch, the Anthropocene, or age of humans. That provides the backdrop for consideration of the interaction between human flourishing and the natural environment.

Many environmentalists assert that a good Anthropocene is not consistent with the ongoing expansion of opportunities for human flourishing which economic growth provides. By contrast, the authors of the Manifesto are optimistic that the Anthropocene can offer expanding opportunities for humans, as well as protecting the natural environment, if knowledge and technology are applied with wisdom.

I endorse this proposition:

“A good Anthropocene demands that humans use their growing social, economic, and technological powers to make life better for people, stabilize the climate, and protect the natural world.”

My problem is with what follows immediately after:

“In this we affirm one long-standing environmental ideal, that humanity must shrink its impacts on the environment to make more room for nature, while we reject another, that human societies must harmonize with nature to avoid economic and ecological collapse.

These two ideals can no longer be reconciled”.

I don’t see any necessary conflict between the two ideals. It seems to me that the ideal of harmonizing with nature means that we should seek to live in harmony with the natural laws of the world in which we live. That means accepting that humans are in many respects like other animals and have deep emotional connections to the natural environment and other living things. These emotional connections are explicitly recognized in Chapter 5 of the Manifesto.

That suggests to me that the problem is just definitional. Nevertheless, it is hard to understand why the authors of the Manifesto would risk losing support by asking people to make an unnecessary choice between ideals.

What is the real choice that the authors want us to make?  When they object to the ideal of human societies harmonizing with “nature”, it seems that what they are referring to are natural systems - the part of the natural environment that has not yet been significantly modified by human activity. 

The authors argue:

“Natural systems will not, as a general rule, be protected or enhanced by the expansion of humankind’s dependence upon them for sustenance and well-being.

Intensifying many human activities — particularly farming, energy extraction, forestry, and settlement — so that they use less land and interfere less with the natural world is the key to decoupling human development from environmental impacts. These socioeconomic and technological processes are central to economic modernization and environmental protection. Together they allow people to mitigate climate change, to spare nature, and to alleviate global poverty”.

The real choice the authors want us to make is between intensifying human activities in particular regions and allowing them to spread in ways that would be detrimental to the natural environment.

The idea of decoupling human development from environmental impacts seems to me to make a great deal of sense as a broad generalization. I expect that governments will encounter difficulties in implementing such a strategy sensibly, but outcomes are likely to be worse if they do not try. One of the difficulties that is likely to stand in the way of implementation in some areas is the need to recognize the rights of indigenous people to use the natural resources they own. Another difficulty is the tendency of over-zealous supporters of wilderness to oppose the eco-tourism which is likely to be necessary to maintain broad political support for protection of wilderness areas. In some areas the involvement of indigenous people in eco-tourism is helping to meet the twin objectives of improving their economic opportunities and enlisting their support for greater environmental protection.

It seems to me to be particularly important for human well-being that attempts to decouple human development from environmental impacts does not occur at the expense of the ideal of living in harmony with nature in areas of intense human activity. The emotional needs that humans have for connection with the natural environment and other living things are unlikely to be satisfied by observing nature on TV and a once-in-a-lifetime visit to a wilderness area. 

Postscript:
In my next post I discuss the link between happiness and feeling connected with nature. 

Is Bitcoin better than gold?

When suggestions have been made to me in the past that I should write about Bitcoin, I have expressed reluctance on the grounds that I don’t know much about it. Some would say, however, that is also true of some other things I write about on this blog.

Time seems to be running out for me to write about Bitcoin while the topic is still interesting. I keep reading news reports suggesting that Bitcoin is rapidly becoming respectable. Apparently New York State’s top financial regulator has just granted the first license to a Bitcoin exchange. A couple of weeks ago it was reported that Goldman Sachs is making a significant investment in a Bitcoin-focused company.

Anyone looking for a simple explanation of what Bitcoin is and how it works can find a fair amount of information online without much difficulty. The Economist attempted to provide an explanation a couple of years ago, but I found an explanation aimed at five year olds to be more helpful. A couple of months ago Nicolas Dorier referred me to the excellent explanation which Andreas Antonopoulos provided to a committee of the Canadian Senate in October 2014. Mr Antonopoulos also appeared before a committee of the Australian Senate and responded admirably to concerns about use of Bitcoin for nefarious purposes such as funding of drug trafficking and terrorism. He also argued strongly that incumbents in the finance industry should not be allowed to dictate government regulations applying to Bitcoin.

Should we view Bitcoin as money? In order to look at this question it is necessary to consider three functions of money: a unit of account; medium of exchange and store of value. Some economists, including Scott Sumner, argue that the unit of account function is the distinguishing characteristic of money from an economic perspective, and I am inclined to agree. Bitcoin is not widely accepted as a unit of account at the moment - it certainly does not seem likely to displace national currencies in that role in the near future.

However, Bitcoin seems to be proving itself to be very useful as a medium of exchange in international transactions. It is particularly pleasing to see reports of Bitcoin being used to enable guest workers from countries such as the Philippines to send remittances home to their families for a much lower price than is charged by firms such as Western Union. Further innovations are occurring in this area. For example, it has been recently reported that an Australian company, Digital CC, has set out to become the Uber of international transfers by developing a peer-to-peer transacting technology to allow remittance payments to be made via a mobile app.

There is no question that Bitcoin is much better than gold as a medium of exchange, because gold is expensive to store and transport.

It is when we consider the potential for Bitcoin as a store of value that the question of whether Bitcoin is superior to gold becomes harder to decide. A glance at the charts below might suggest that investors in Bitcoin are being optimistic if they think it will soon be accepted as a reliable store of value.

How much attention we should pay to past volatility in the price of Bitcoin in thinking about its potential as a store of value in the future?

The author of an article in Fortune, entitled ‘Gold vs. bitcoin: An apocalyptic showdown’, has suggested:

“Of course, as a new technology, bitcoin is subject to much more volatility than gold. But over the long run, given the fact that no new bitcoins will be mined after the 21-millionth, we can expect it to ultimately serve as a better store of value than gold”.

I feel inclined to agree. However, the more difficult question for me is whether to put my money where my mouth is. 

Postscript:
Nicolas Dorier has provided the following response:

"There is nothing to to fear about Bitcoin, but like owning gold, if your lose the map where you buried it, you lose everything. So one should be confident in his ability to protect the map. To learn how to do so, one should start training by protecting some pocket money first before burying his treasure.

First, start small, and consider it a learning experiment rather than an investment. Bitcoin is relatively new, and the tools and ecosystem are not as user friendly as they will become. The learning curve might be a little steep. Owning Bitcoin means being responsible for your money, and most people are not responsible of their own computer.

So be careful, you can always try to buy a few (for 10-50 dollars), and play with it by trying to buy stuff, transfer them between addresses, backup them on paper etc, restore them etc. This stuff was easy to learn for me as I am a developer. But it is not for most people. 

Second, never let your bitcoin on fiat/bitcoin exchanges once you bought. You don't own bitcoins if you don't own the private key. Any balance you see on exchanges are just IOU, not bitcoins.

By playing with it you will learn little by little all what you can do with it that you can't with traditional fiat currencies, and all the business opportunities that it opens. But don't rush it, start playing with it first.

Bitcoin is also an hedge against monetary mismanagement and financial oppression, a typical example right now is Argentina.

The value of Bitcoin increases when governments take measures to restrict the movement of other forms of money. As they do everything to restrict it, it forces people to use bitcoin. Not because they believe or use it as store of value, but because, it is easier to transact. (It is for this reason that Bitcoin came to be used first in black markets.)

As the failure of our central banks becomes more and more obvious, they will start to impose capital controls. (War on cash, that you start to see happening everywhere). This is mainly what will ultimately drive the value of Bitcoin."