Discounting the Bright Green Future
The Biden administration’s proposed new 2030 tailpipe standards for automobiles is attracting a lot of attention and criticism for its indirect attempt to coerce Americans to buy electric cars whether they want them or not, or whether the electricity grid can handle it, which is doubtful. But another far-reaching technical move by the Biden administration could have a much larger and more insidious effect well beyond cars, but is attracting almost no public attention.
Biden’s Office of Management and Budget (OMB) has issued new guidance for performing cost-benefit analysis of regulations. The key change in the guidance is lowering the “discount rate” government agencies should use from 3 percent to 1.7 percent. I know—you’ll need to contain your outrage, and resist the urge to rush to the barricades.
Although the use of discount rates has been essential to mainstream financial and economic analysis for more than a century, it is arcane to the general public. Discussion of the issue puts people to sleep, and thus only takes place among economists, who, the old joke goes, are people who lack the personality to be accountants. But this is a hugely important technical question, in this instance being driven by politics rather than sound economic analysis.
The significance of the Biden proposal for a 1.7 percent discount rate is simple: the Left wants to be able to claim huge economic benefits from costly and onerous regulations including requiring expensive electric cars, replacing natural gas stoves and furnaces, putting solar panels and windmills from sea to shining sea, not to mention lots of other regulations from other government fiefdoms. But it requires understanding why fixing the discount rate—already unrealistically low at the presently-used 3 percent—is necessary for this shell game to work.
One simple way to understand how a discount rate works is to ask yourself if you’d prefer to have $1 today, or $1.10 a decade from now. The answer depends on your discount rate. At the Federal Reserve’s 2 percent target rate of inflation (inflation is a good baseline for settling on a discount rate), to have the same purchasing power ten years from now you’d need to have $1.22 to stay even. Thus having $1 today is better than $1.10 a decade from now. Today of course inflation is running much higher than 2 percent. If we averaged only 5 percent inflation for the next decade, you’d need $1.63 to have the same purchasing power as $1 does today.
The analysis is reversed somewhat when analyzing present costs against future returns, whether for capital investment or determining whether government regulations will provide net economic benefits. The question of what discount rate the government uses has been central to climate policy for two decades now.
When it comes to "climate change," conventional economics has been an obstacle to the world-changing dreams of the activists. All of the “consensus” climate forecasts claim that unchecked global warming will impose large economic costs, but not for more than 50 years from now or longer. So how much should we spend today to prevent the high future costs? Using any realistic discount rate, the answer comes back: very little, because a dollar today is worth a lot more than a dollar 50 years from now.
Here's a simple example: if you assume $1 billion in climate costs 50 years from now, how much should you spend today to avoid that cost at the present 3 percent discount rate? The answer is $228 million. But at a 1.7 percent discount rate, the answer is much larger: $430 million.
You can see where this game is going: with a realistic discount rate, most of the billions and billions we are spending for green energy and other climate-driven causes will badly fail a cost-benefit test. Only by using an absurdly low discount rate will the huge costs of the climate crusade seem economical. The talking point goes something like this: “Yes, this project will cost $1 billion, but it will avoid $2 billion in costs down the road [50 years from now],” relying on the innumeracy of the public not to see through the flim-flam. (This assumes, of course, that projected costs of future global warming are reasonable in the first place, but that dubious contention is a subject for another time.)
While the rate of inflation is a good place to start in thinking about how discount rates work, inflation is only half the story in using discount rates. The other baseline is the cost of capital (think interest rates over time). Corporations use discount rates to calculate the optimal use for their limited capital between investment options, and always employ a discount rate above their long-term cost of capital, typically 7 percent or more depending on the time horizon for the investment. (In periods of high inflation like the present, discount rates generally go up commensurately.)
While the government might be justified in employing a lower discount rate than the private sector for the case of public goods, the proposed 1.7 percent rate is absurd. No one outside of government climate circles uses a discount rate this low. As a matter of sound public administration, government should use realistic discount rates to allocate their scarce capital for projects that deliver the best returns for taxpayers, rather than projects favored by politically connected activists and rent-seekers.
But that’s not the only way the Biden regulators are trying to tilt the playing field in favor of uneconomic spending. Because the costs of green energy are highly regressive (low-income people spend a higher proportion of their income for energy), the Biden regulators assert with scant evidence that low-income people bear a disproportionate share of the harm from global warming and other pollution, thus justifying higher costs for low-income households. This they will call “environmental justice,” which can be thought of as an attempt to rebuild the Edmund Pettus Bridge over the Cuyahoga River fire.
Even if you believe the climate change religion, this kind of economic illiteracy is preposterous. One person who has been making this point for years now is Nobel-winning economist William Nordhaus of Yale University. Although Nordhaus is a believer in the “consensus” that climate change is a serious future problem that ought to be addressed, when he won the Nobel Prize for his work on climate economics pointing out that spending trillions today makes little economic sense, climate change activists said: “Shut up.”