Intergenerational Discounting and Market Rate of Return

in OLG version of RICE Model

Polbin Andrey, RANEPA, +7-926-6042749,

Lugovoy Oleg, EDF, RANEPA, +7-916-6709196,

Overview

Conclusions about the optimal reduction of greenhouse gas emissions are substantially dependent on discount rates, under which costs benefits analyses are evaluated. There is the international debate about appropriate discounting in policy analyses. If the future benefits discounted at a rate compatible with market real interest rates, the optimal reduction of GHG’s emissions should be moderate in the early period with more aggressive emission cuts later (Nordhaus, 2008).

However the use of high time discount rates is inconsistent with classical utilitarianism, which holds that equal weights should be attached to the welfare of present and future generations (Arrow et al., 1996; Broome, 1992; Cline, 1992; Ramsey, 1928). Therefore an intergenerational discount rate should equal to zero. This view is taken by Stern (2007) who applies though not zero but low social discount rate (0.1% per year, and elasticity of marginal utility of consumption equals to 1). Stern (2007) concludes about the need for extreme immediate actions in greenhouse gases emission reduction. The main critics of these assumptions are that results of the Stern model are not compatible with today’s real returns on capital and saving rates (see, for example, Dasgupta, 2007; Nordhaus, 2007; Wietzman, 2007, among others). Real returns are extremely low and saving rates are extremely high.

In this paper we introduce an overlapping generation framework with seven generations in the RICE model (Nordhaus and Yang, 1996). We consider competitive equilibrium where “global” government follows Ramsey type optimal policy (Ramsey, 1927) and set emissions control rates maximizing utilitarian welfare function treating all generation in all regions equally. As we consider competitive equilibrium we avoid Negishi weighting and could specify and solve the model in a more natural way. The model provides two discount rates: the social planner discount rate under which costs benefits analyses of climate projects are evaluated and the market discount rate for investments in physical capital. By distinguishing the two discount rates it is possible to give each generation equal consideration while still allowing for individual impatience. So this framework is a natural way to separate equity and efficiency. Regional specification of the model allows us to investigate regional-specific policies and to analyze welfare gains and loses of different generations in different regions along optimal emissions reduction path in comparison to alternative policies.

Methods

Computable dynamic general equilibrium modeling.

Results

Under plausible calibration simulation results of the model indicate to a more radical global emissions reduction than in the original RICE model. Emissions control rates are very different across regions. Major beneficiaries from the RICE-OLG optimal policy are generations to be born in the poor countries in the next century.

Conclusions

The limitations in calibration of the integrated assessment models to the market rate of return can be avoided by switching from infinitely lived agent (ILA) to overlapping generation framework, and from centrally planned to the market economy. We argue that OLG framework in integrated assessment modeling could resolve the issue about consistency of models with real returns on capital and more fair treatment of different generations. The model can well reproduce the path of real returns of RICE model and the results of the analysis are in favor for a more drastic reduction in emissions compared with baseline run of RICE model. Assumptions used in the model could rationalize more radical GHG emissions reduction without significant influence on real returns, saving rates and capital-output ratio.

References

Arrow, K. J., Cline, W., Maler, K.G., Munasinghe, M., Squitieri, R., Stiglitz, J., 1996. Intertemporal equity, discounting and economic efficiency. In “Climate change 1995 - economic and social dimensions of climate change”, Eds. Bruce J., Lee, H., Haites, E. Cambridge: Cambridge University Press, 125–44.

Broome, J., 1992. Counting the cost of global warming. Cambridge: White Horse Press

Cline, W. R., 1992. The economics of global warming. Washington: Institute for International Economics.

Dasgupta, P., 2007. Commentary: the Stern review’s economics of climate change. National Institute Economic Review 199.

Nordhaus, W. D., Yang, Z., 1996. A Regional Dynamic General-Equilibrium model of alternative climate-change strategies. American Economic Review 86 (4), 741-765.

Nordhaus, W. D., 2007. A review of the "Stern review on the economics of climate change”. Journal of Economic Literature 45, 686-702.

Nordhaus, W.D., 2008. A question of balance: weighing the options on global warming policies. Pre-publication version,

Ramsey, F.P., 1928. A mathematical theory of saving. Economic Journal 38, 543–559.

Stern, N., 2007. The economics of climate change: the Stern review. Cambridge: Cambridge University Press.

Wietzman, M. L., 2007. A review of the "Stern review on the economics of climate change”. Journal of Economic Literature 45, 703-724.