Discounting and the representative median agent

Produced as part of the Managing climate risks and uncertainties and strengthening climate services CCCEP research programme theme

Social discount rates (SDRs) are used in cost–benefit analysis to determine the present value of future costs and benefits: for example, to determine how much today’s society should invest in mitigating the impacts of climate change in the future. When a positive SDR is used, less value is placed on future costs and benefits than on present ones. This is often justified by the expectation that future generations will be wealthier than current generations. The change in society’s wealth is usually measured by the expected average (mean) income growth.

In this research, Emmerling et al. show that by using the growth of the mean income in the SDR, changing income inequalities are ignored – an important omission for public policy analysis. They propose an ‘inequality-adjusted’ SDR that takes changing inequalities into account, using the difference between growth of the mean and median incomes to better represent the economic growth experienced by the majority of society. This measure could easily augment government guidelines on public investment (e.g. in the UK, EU, Germany, France), since median income growth is routinely collected by national statistical organisations. The findings could also augment international guidelines on the estimation of the social cost of carbon from the Intergovernmental Panel on Climate Change and the US National Academy of Sciences.

Key points for decision-makers

  • Social discount rates (SDRs) describe future costs and benefits in present values. They can be used to determine how much today’s society is willing to invest to mitigate costs of climate change in the future.
  • The SDR depends on economic growth because it is assumed that an additional benefit or cost to a wealthier future society is worth less than to the relatively poorer present society.
  • Current practice uses the growth of mean income to capture this wealth effect. This ignores changes in income inequality over time and is skewed by income growth among the rich.
  • The growth of median income better reflects the performance in the middle of the distribution. For instance, in the US over the past 30 years, mean income has grown by 1% but median income by just 0.3%.
  • This research therefore suggests using an ‘inequality-adjusted’ SDR which reflects growth of median rather than mean income to represent the economic growth experienced by the majority of people in society.
  • In the UK and US, using this adjustment leads to a reduction in the SDR of up to 1%, indicating that if society is inequality-averse, the cost and benefits of climate change to future societies are systematically undervalued.