Economists use a standard formula to determine the effective discount rate on everything from pork belly futures to cap-and-trade contracts. It works perfectly on paper, but in the real world that formula ignores one critical factor—human nature. And that omission can have a profound effect on how policymakers combat climate change, argues Elke U. Weber, Jerome A. Chazen Professor of International Business and director for the Center for Research on Environment Decisions in the Earth Institute and Center for Decision Sciences at Columbia Business School.
Discounting of future consequences is used in the cost-benefit analyses of incentive-based environmental policies, such as emission fees, tradable permits and voluntary regulations. These popular market-based strategies have been effective in curbing carbon emissions in developed countries, but especially strategies that target consumers could potentially be more effective, if tailored to the behavioral characteristics of these decision makers, Weber says.
Another problem is that current economic models may not sufficiently account for the vast social and psychological disparities between developed and developing countries. “As a result, innovative policies that have worked well in industrialized nations could failing in developing economies,” she adds.
People Are Quirky
Discount rates are used to determine the present value of future gains or losses based on current interest rates and are adjusted using preset factors for time and risk. Those things being equal, the discount rate used is the same, regardless of whether we are taking about future income or future health, gains or losses, and whether the individual will personally experience the gain or loss or if it will be accrued to future generations. In the real world, though, people don’t work that way.
For example, delaying benefits creates risk, and investors will discount the future value of delayed benefits based on their perception of that risk—the higher the risk, the steeper the discount. When it comes to future losses, though, some people would rather pay now than have the threat of future pain hanging over them, so they often won’t discount losses. “In other words, the waiting period itself can have positive or negative effect on the discount rate,” Weber says.
Accounting for Cultural Differences
In her recent paper, “Chinese Discount Future Financial and Environmental Gains But Not Losses More Than Americans,” Weber and co-authors Min Gong and David H. Krantz, both with the Center for Research on Environmental Decisions and Min Gong now at the Rand Corporation, explore whether financial and environmental future consequences are discounted similarly and examine how cultural differences impact discount rates. The authors focused on China because it’s the world’s No. 1 industrial emitter of atmospheric carbon dioxide, and is about to embark on the use incentive-based policies to curb emissions.
To get a better understanding of what could work in China, the authors surveyed US and Chinese participants to measure the discount rates they would apply to a variety of financial and environmental scenarios. Each participant made a series of choices between immediate and one-year delayed outcomes.
For the environmental questions, participants compared either a small increase in the population of a species of fish in a national park right now and a larger increase one year later (a gain), or a small decrease in the number of old trees in a forest and a larger decrease one year later (a loss). For the monetary values, participants chose between a smaller amount of monetary gain or loss now and larger amount of monetary gain or loss later.
The research found that environmental existence values (future levels of fish or old trees) were discounted in similar ways than future monetary outcomes. But there were some cultural differences. Chinese participants discounted gains, but not losses, in both the financial and environmental scenarios more than Americans. “Living in a rapidly changing society and facing more economic volatility, Chinese were more concerned about the insecurity and uncertain value of future gains, and had higher expectations for returns they could receive were they to invest the gains without delay,” the authors concluded.
This insight into how different societal factors influence discount rates gives policymakers a new tool, Weber says. For example, this research shows that China may be more effective in cutting carbon output by framing its policies around the concept of future losses rather than future gains.
Similarly, incentive programs that offer immediate rewards, such as an instant rebate on a new energy-efficient air conditioner, will be more effective than one with a future reward, such as a tax credit. “You have to know how your people are responding to risk, uncertainty, and time delays in order to create the right incentive-based policies,” Weber says.