Reviewing Social Discount Rates

There is a strong case for factoring in the equity issue when discounting benefits and costs of intergenerational projects such as those designed to combat climate change and environmental degradation, an Asian Development Bank (ADB) survey has found.

The study argues for a possible reconsideration of the standard discount rate applied by multilateral development banks (MDBs).

“For MDBs that provide development assistance to developing countries through capital investment, there could be a case of reviewing their decades-old practice of applying a uniform discount rate of 10–12% to all projects to see whether this practice is still appropriate in a changing world,” the survey concluded.

The survey’s authors define the social discount rate as a reflection of a society’s relative valuation on today’s well-being versus well-being in the future. The appropriate selection of a social discount rate is crucial for cost-benefit analysis, and has important implications for resource allocations. There is wide diversity in social discount rates, with developed nations typically applying a lower rate (3–7%) than developing nations (8–15%).

The subject of a social discount rate, always a source of fierce debate between economists, has become highly controversial since the publication of The Economics of Climate Change: The Stern Review. The publication exploded on the global warming scene in 2006 with its dire warning that global gross domestic product (GDP) was at future risk of a 20% reduction if there was a failure to invest 1% of world GDP now to reduce global warming. However, critics questioned the findings on the basis that they were arrived at using an extremely low discount rate of 1.4% used in economic modeling.

ADB’s study surveys the voluminous literature on the social discount rate, including an examination of the four main alternative approaches for the “real world where markets are distorted.”

There is no consensus among economists and, according to the survey, no “one-size-fits-all” solution to the choice of social discount rate, owing to national variations. A regular reassessment and readjustment of the social discount rate used by each country is therefore required. The review needs to be conducted in view of altered local economic circumstances and international capital market conditions, ADB’s survey concludes. •