Determining discount rates for the evaluation of natural assets in land-use planning: An application of the Equivalency Principle

Highlights

• The Equivalency Principle tends to result in lower discount rates than market rates.

• Rates based on the EP were estimated for 11 European countries.

• Results support the premise of geographically differentiated discount rates.

• Results show rates ranging from 0% to 11% across all European countries.

• An average discount rate of 1% across study sites was estimated.

Abstract

One of the most pressing issues when making decisions over long-term environmental problems is deciding on an appropriate discount rate. This can be a highly technical discussion. While some argue in favour of market rates, which usually tend to be high, others support the use of near-zero rates to ensure that both current and future generations are properly accounted for. This paper presents an alternative approach to determining the discount rate for environmental assets in the case of land-use planning - the Equivalency Principle (EP) - based on the normative proposition that the social value of protected natural land should be at least the same as the market price of an adjacent land with similar environmental characteristics that has been granted permission for development. The paper first provides a theoretical overview of the approach, followed by an application of the EP at the land plot level across 11 European countries. Based on the EP, pure rates of social time preference that would equate natural and development land values within each administrative unit have been calculated. The findings show that the application of the EP usually results in discount rates that are lower-than-market rates and that are geographically differentiated. This implies discount rates that account for preferences of the society where the land or natural resource is located, with results ranging between 0% and 11%, with an average rate of 1% across study sites.

Introduction

Decisions with consequences that occur over the long-term are widely known in economics as inter-temporal choices. Indeed, inter-temporal decision-making has been studied during the last 80 years through the Discounted Utility (DU) model, formulated by Paul Samuelson (1937). The DU model assumes that society prefers to receive benefits in the short-term while delaying costs to the future, by “exponentially discounting the value of outcomes” as they occur further in time, thus placing decreasing weight on the value of future welfare. However, if lower discount rates give higher value to future generations more likely to suffer from environmental impacts, but come at a cost of greater economic sacrifices to the current generation, then what is the most appropriate discount rate to use?

The classical framework for representing inter-temporal choices has been widely disputed over the years for the use of market rates. Bromley (1998) says that traditional sustainability approaches based on commoditising natural assets, and making judgements of welfare and utility across generations (and across infinitely many time periods) cannot stand because the desires, valuations and preferences of future generations are totally unknown and unknowable to us. Based on this, Bromley asserts that we should follow rights-based approaches to sustainability wherein those living now agree to preserve ‘settings and circumstances’ for the future. Gowdy (2004) on the other hand, argues that based on the considerable evidence showing that people value the medium and distant futures the same (hyperbolic discounting), straight-line discounting (whereby the future is discounted at the same rate during all future time periods) may seriously underestimate the benefits of long-term environmental policies. After a comprehensive discussion on environmental discounting in his book Greenhouse Economics: Value and Ethics, Spash (2002) boils the debate down to one between ethics and economics. While acknowledging this, he ascertains that: ‘The contradiction is that economics takes a very specific philosophical and ethical position and then tries to deny the relevance of ethics in economics. The conflict of values remains despite the attempts to remove their explicit discussion from the economic debate” (Spash, 2002, p. 188, p. 188). A significant milestone came in 2007 with the Stern Review on the economics of climate change, which advocated for the use of near-zero discount rates for representing intergenerational preferences on climate change (Stern, 2007). Its publication received mixed reviews. Several leading economists, such as Dasgupta (2007) and Weitzman (2009), agree wholly with the use of low discount rates given the inadequacy of traditional neoclassical frameworks for addressing environmental issues characterised by irreversibility, uncertainty and long-term horizons. Others, while agreeing on the need for action on climate change, considered the Review incomplete and its conclusions ambiguous from an economic perspective (Tol, 2006, Tol and Yohe, 2006). Indeed, in his appraisal, Nordhaus (2007) argues that the Review confuses two fundamental concepts of discounting. The first, defined as the “real interest rate”, relates to the annual percentage increase in the purchasing power of a financial asset, measured by the nominal or market interest rate on that asset minus the inflation rate (Frank et al., 2007). The second, called the “pure rate of social time preference”, is concerned with the economic welfare of households or generations over time. It describes the rate at which society is willing to postpone a unit of current consumption or expenditure in exchange for future consumption. The pure rate of social time preference has been proposed as a social discount rate for public projects in general, given the consideration of intergenerational equity for long-term projects (Scarborough, 2011). Therefore, unlike the real interest rate, which deals with future goods or investments, the pure rate of social time preference involves the discounting of future welfare. In this case, a discount rate of zero would ensure that present and future generations are treated equally, whilst a positive rate would imply a reduction in the value placed on the welfare of future generations compared to the present generation.

When discussing the use of near-zero rates proposed by Stern, or Nordhaus's support of real (market) interest rates close to 6% per year, Beckerman and Hepburn (2007) assert that the choice of either alternative is not trivial, and may have a decisive influence when assessing the economics of climate policy. Instead, they propose an intermediate approach based on the use of stated preference surveys, behavioural experiments and methods for determining discount rates reflective of social preferences. Conversely, Philibert (2006) proposes to assign a growing value over time to environmental assets that are not substitutable and not reproducible, or alternatively, he suggests the use of declining discount rates to account for the uncertainty of future economic growth. Others, such as Cropper and Laibson, 1998, Gollier, 2008 and Groom (2014) agree with Philibert's assertion of declining rates. Chichilnisky (1996) argues that no generation should prevail over the other, and similarly proposes the use of a conventional, market-based, discounting approach in the near-future and a rate of zero after an inflexion point. Certainly arguments for the use of declining discount rates are often justified on the basis of: uncertainties related to market-based rates or behavioural changes in the long-term, or due to the aggregation of heterogeneous pure rates of social time preference. It seems that during the last decade a non-official consensus has been reached in favour of social discount rates that decrease in the long-term (Groom, 2014).

Since the early 2000's the notion of dual-discounting has been emerging as a way to value environmental goods and services separately and differently from other costs and benefits (Tol, 2003, Yang, 2003). For example, Gollier (2010) argues in favour of an ecological discount rate smaller than the economic discount rate, where he estimates that changes in biodiversity be discounted at a rate of 1.5%, while changes in consumption be discounted at a higher rate of 3.2%. By separating the environment from other market goods and services, the approach ensures that future environmental assets are not undervalued or that the [economic] discount rate applied to them is not too large (Gollier, 2010). Indeed, as Weikard and Zhu (2005) argue, dual rate discounting can be justified in cases where future prices for environmental goods are unavailable, or when market goods and environmental goods are not substitutable. This seems reasonable given that many environmental restoration or enhancement projects carried out by governments would be otherwise unable to meet decision-making criteria based on conventional CBA and discounting practices (Almansa and Martínez-Paz, 2011). But Green and Richards (2018) argue that the way that humans value monetary goods should not be confounded with the way they value environmental goods. In their paper based on experimental evidence, the authors find that individual discounting behaviour, while varying widely across environmental goods, generally tends to be exponential, such that individuals discount environmental goods at lower rates compared to monetary goods. The evidence-base suggests that humans share a complex relationship with the environment unlikely captured by traditional economic valuation methods. Supporting this point, Adger et al. (2011) observe that climate change policy tends to disregard the relationship between aggregate measures of human welfare and the environment, that is, the “emotional, symbolic, spiritual, and widely perceived intrinsic values of the environment.”

The main focus of this paper explores the complex relationship between people and the environment. In particular, it seeks to address the various trade-offs between conservation and development, and the common undervaluation of natural resources within conventional decision-making frameworks. Building on the literature on dual-discounting, this study suggests an approach for determining the discount rate for environmental assets in the case of land-use planning – the so-called Equivalency Principle (EP). This is based on the normative proposal explained in Chiabai et al. (2013), which argues that when one of two identical pieces of natural land located in the same administrative unit has been granted permission for development, market distortions stemming from regulations and externalities arise that will cause these two lands to be valued differently. This situation generates an anomaly that potentially may have deep ethical and environmental implications, as it may generate incentives to urbanise natural land rather than to use or restore existing urban land. The authors propose that both pieces of land should be valued equally, as the present value of both is at least equivalent, and subsequently, future generations are likely to give them equal utility and economic value. An important benefit of this approach is that it avoids making assumptions about the expected welfare or growth rate of consumption of future generations, and the magnitude of projected uncertain impacts for example due to climate change, which might materialise differently in the future.

Applying the EP, this paper estimates discount rates for several types of natural assets across Europe, based on the hypothesis that rates are likely to differ geographically, reflecting the preferences of the society where the land or natural resource is located. The objective of this study is thus to develop the EP as a practical rule of thumb that could guide investment decisions in the context of environmental and resource economics, and help to justify the use of lower-than-market discount rates for valuing environmental assets and ensuring sustainable land-use planning on both ethical and economic grounds.

The rest of the paper is organised as follows: Section 2 first discusses the theoretical basis of the EP including its economic rationale and caveats, followed by an explanation of the methodological approach applied in this study. Section 3 presents the results for over 300 sites across Europe. Section 4 discusses some of the main findings and section 5 is devoted to conclusions.