Time horizons and discount rates

Another challenge concerning the costs and benefits of adaptation relates to the profile of adaptation costs and benefits over time (OECD, 2015a). In many cases, the impacts of climate change only occur (significantly) in the future, notably beyond the 2040s. The full benefits of adapting to these future impacts therefore arise in the longer term as well, although costs may be incurred earlier.

In economic appraisal, the timing of costs and benefits matters. This reflects the principle that, generally, people prefer to receive goods and services now rather than later. This time preference is captured by discounting – a technique used to compare costs and benefits that occur in different periods. This applies discount rates to convert future costs or benefits to present values. As shown in Table 3, the choice of the discount rate is important:

Table 3 shows that, with a discount rate of 1 percent, USD 100 in five years’ time is equivalent to a present value of USD 95, but at a discount rate of 10 percent, this falls to USD 62. Using the standard social discount rates (or economic internal rate of return thresholds) that are typically used in economic appraisal, especially in developing countries, the economic benefits of future adaptation are therefore small in present value terms when a high discount rate is used. This makes it difficult to justify high upfront adaptation costs today for benefits that occur in the future. These issues are amplified for year 20 and especially for periods longer than this.

When lower discount rates are used, higher weight is given to benefits in the future. Conversely, the higher the discount rate, the less the future will count in today’s choices. This is important. Developing countries (and overseas development assistance and international finance institutions undertaking economic appraisal in these countries) use social discount rates that are high, e.g. 10 percent or higher (OECD, 2015a).11 This significantly affects the economic benefits of longer-term adaptation. There are different ways that social discount rates, i.e. ones that are used in economic appraisal, are derived (see Box 3).

Basically, the discount rate operates like the lens of a reversed telescope. It deforms the temporal perspective and alters the consideration of the long-term effects of today’s choices. The effect is very marked if the discount rate is high and the period is long. Therefore, when a social planner has to invest resources in the perspective of future benefits (or harm reduction), the choice of the social discount rate (SDR) is decisive.

Nevertheless, discounting is used in all economic appraisals, and a high discount rate means that future benefits are given less weight in today’s choices. The problem has particular importance for those environmental choices that have irreversible effects. To correct for these effects, some authors suggest considering a lower discount rate to evaluate benefits that are more distant in time (Arrow et al., 2014; Arrow et al., 2013).