Focus on Terminology: Social Discounting

Examining terms and their evolving, specialized meanings for actuaries

SAM GUTTERMAN

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The Actuary’s “Terminology” series, developed in collaboration with the SOA Research Institute’s Catastrophe and Climate Research Steering Committee, seeks to address inconsistent, evolving and complex terms that may require further explanation or examples. These terms are either new to actuaries or may be used differently by actuaries, climatologists, sustainability experts and other stakeholders.

This second installment in the series focuses on “social discounting” (the first was on “modeling”). As actuaries, we commonly use long-term discount rates to assess the value of future cash flows and liabilities. These rates are set according to the valuation’s aim, the nature of the liabilities and regulatory requirements. Here, I extend this familiar concept to the social cost-benefit analysis of strategies for mitigating and adapting to increasing climate risk and extreme weather.

The following outlines a framework for setting suitable social discount rates, demonstrates its use and explores the basics of social discounting and related challenges.

“SOCIAL DISCOUNTING”

Social discounting is the process used to assess whether or to what extent an action under study is an effective use of society’s resources, considering the social value of the costs and benefits involved. A social cost-benefit analysis of the financial effects of such an action incorporates estimates of the costs and benefits expected to be experienced by all stakeholders, both directly and indirectly affected. It is a vital element of social decision-making and many risk management processes, particularly when costs and benefits are spread over an extended period.

The social discount rates used in these analyses quantify the current value of future costs and benefits, representing weights applied to corresponding projected cash flows that reflect the value associated with time and risk.

A social cost-benefit analysis is used to evaluate a strategy, project or investment involving the public interest. Usually conducted from a public-sector perspective, it reflects related social externalities and co-benefits, focusing on social value. (Social externalities include secondary costs and benefits that are neither the direct costs nor benefits of a program that may not involve the decision maker. Co-benefits are generated by the same or related sources but affect different players, especially if their drivers are shared.)

Analysis can be applied to a wide range of issues and projects, including those where governmental rules or mandates drive actions by the private sector. In addition, many of its concepts may also apply to analyzing private sector investments involving social issues with a long planning horizon.

The following addresses the fundamentals of the social discounting process and several contentious related issues, including the role of market rates and their methods and assumptions.

Although actuaries have not been active in discussions of this application of discount rates, their experience with discounting cash flows over extended periods in a broad range of applications suggests they can provide valuable insight into this process.

Why climate-related risk is different

Discount rates have been formulated in several ways, including these four:

1. Risk-free
2. Market or financial based
3. Consumption based
4. Social discounting

In this application, social discounting is used to determine the most appropriate actions to pursue in the mitigation of or adaptation to climate change.

These social discount rates may differ from those used in other public- and private-sector cost-benefit analyses because of factors including these nine:

1. Social externalities and co-benefits, such as air pollution, whose drivers are shared, are generally not considered in market-sector transactions
2. The (mostly) irreversible nature of greenhouse gas accumulations in the atmosphere and oceans
3. The global impact of mitigation
4. The ultra-long periods involved, often measured in decades or even centuries
5. Its complexity, from emissions to damages
6. The sheer size, severity and long-term nature of the risks involved, touching numerous human endeavors
7. The significant uncertainties involved, including low probability but enormous tail risks that make marginal analysis inappropriate
8. Its social aspects dealing with public goods, and
9. Qualitative, intangible, non-monetizable and ethical risks, including intergenerational equity and sustainability.

There is no unique or consensus set of social discount rates, nor a single approach for determining them. Some experts approach climate change analyses using a market-based rate. Other experts believe that unadjusted market-based discount rates may not be optimal for social discounting, while others approach the analysis by applying below- market rates. This process could include a social premium for risk or be influenced by the effects of social externalities and sustainability needs. There could, however, be certain exceptions (e.g., short-term adaptation projects and costs and benefits after an event occurs).

Taking a look at social discount rates

The (Frank P.) Ramsey formula, named after a famous early twentieth-century economist, has been a foundational approach for discounting for a long time. It is a growth model, commonly used to analyze long-term investments affecting multiple generations for safe social investments, containing both a precautionary factor and a wealth effect. Extensions of this formula are needed to address the considerations described here, including its assumption that costs and benefits are marginal and its emphasis on the affordability of an investment rather than its irreversible social and financial effects.

Social discount rates should be scenario specific. Because of the sensitivity to the long timeframes involved, the size of its possible consequences and the uncertainties involved, a range of social discount rates may be used to reflect the attendant risks.

Risk and uncertainty

Uncertainty is an essential consideration in a temporal-spatial framework of a social cost-benefit analysis of climate risk. Actuarial principles dictate that the discount rate(s) should be compatible and consistent with the cash flows or their equivalents, neither double-counted nor ignored. Actuarial approaches applied in a cost-benefit analysis typically include stochastic or scenario analysis to account for uncertainty. One approach is to use a close-to-market rate for the short term, declining thereafter to avoid undue bias among competing projects.

The enormous tail risk, typically assessed based on expert judgment, is associated with significant additional costs and damages; tail risk can be a key driver of decision-making. This may lead to a greater use of scenario analysis than for other social issues.

Qualitative analysis, ethics and intangibles

Qualitative and ethical aspects of social cost-benefit analyses include equity across and within generations, non-monetizable items, social externalities and long-term sustainability. They can be difficult to quantify. For example, intergenerational issues could potentially decrease the social discount rates, although a zero-time approach advocated by some is also not suitable in my view. Many believe it is a social obligation for each generation to leave the Earth in a comparable condition to when they inherited it, rather than in a deteriorated condition.

There are several types of non-monetizable elements and public interests (i.e., not translatable into cash flow equivalents), such as heritage sites, ocean quality, human lives and health, and other difficult-to-quantify areas (e.g., quality of life and health, intangible social externalities and provision for long-term sustainability), to consider in a social cost-benefit analysis. There is no singular method to account for them, either quantitatively or qualitatively, expressed in terms of expected frequency, severity, timing and degree of confidence.
Nevertheless, because of the public nature of the decisions considered by social discounting, transparency is essential concerning the basis of the cost-benefit analysis and the treatment of potentially non-monetizable costs and benefits.

Applications

Human mitigation efforts can affect greenhouse gases, and the benefits can be viewed on a global basis. Adaptation, focusing on protection against specific losses and damages, can be addressed at regional, national, and local levels. Also, due to different timeframes for mitigation and adaptation, adjustments in discount rates can be smaller for analyzing potential adaptation actions.

Adaptation actions are primarily national or local, although, especially when a disaster arises in a less developed area, supranational development organizations, philanthropic foundations and foreign governments can provide assistance. This underscores the need for risk-pooling and risk-transfer mechanisms, such as private or public sector insurance, supported by regulatory and organizational oversight.

Global values of uncertainty and risk aversion, among other things, can be challenging to determine due to a lack of consistent data, so broad estimates or careful averaging may be necessary.

The social cost of carbon (an estimate, in monetary terms, of the damage caused by emitting one additional metric ton of carbon dioxide into the atmosphere) is an important application of social discount rates. It is the marginal (in present value terms) cost of expected damages resulting from one metric ton of CO₂ emission. A lower social discount rate will lead to a larger social cost of carbon. (Similar calculations can be performed for methane and nitrous oxide.)

Due to different social discount rates, a wide range of social cost of carbon estimates have been developed. Unsurprisingly, those predisposed to fight for climate change action favor low discount rates, while the opposite is the case for those who do not believe such goals are worthwhile.

Timing and real options

A cost-benefit analysis involves not only how much to spend and what to spend it on, but also when to spend it, especially in an uncertain environment. Real options analysis, addressing the right, but not the obligation, to undertake a specific action, can be used to determine the value of options regarding the timing of decisions, whether by choice or necessity.

Decision trees (analytical tools used to evaluate different decision paths under uncertainty) and probability distributions (representing the range and likelihood of different outcomes under uncertainty). These can be used to analyze the cost and desirability by considering costs (e.g., increased accumulation of greenhouse gases in the atmosphere and oceans) and benefits of delays (e.g., possible enhanced technology, better information and planning), as well as the availability of financing or other resources.

Statements of fact and opinions expressed herein are those of the individual authors and are not necessarily those of the Society of Actuaries or the respective authors’ employers.

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