A Dual Probabilistic Discounting Approach to Assess Economic and Environmental Impacts

Abstract

AbstractThe growing environmental concerns require the characterization of decision support methods that can guide analysts towards more sustainable investment choices. Therefore, in the ex-ante economic evaluations of investments with environmental repercussions, it is of rising interest to give the “right” value to the non-monetary effects in the long term. In this regard, conventional discounting procedures—based on constant rates—are inadequate to evaluate intergenerational environmental effects. With this research we propose an innovative model for estimating discount rates to be used in the Cost–Benefit Analysis (CBA) of projects with long-term environmental effects. The model is based on a two-goods extension of the Ramsey formula, according to which the rate at which environmental impacts are discounted is different from the rate at which monetary benefits are discounted. Compared to the Ramsey model, we propose time-declining functions of the two discount rates to assess the long-run effects of investment projects. To characterize the model, we consider the macroeconomic risk, or we assume that the variable “GDP growth rate” is a stochastic variable. Furthermore, since we propose discount rates to evaluate public projects in line with sustainable development goals, we express environmental quality as a function of the Environmental Performance Index (EPI). Based on the proposed model, we estimate for the first time declining consumption discount rates and declining environmental discount rates for Italy based on empirical data. The estimates of the two discount rates for Italy shows that the environmental discount rate is lower than the consumption one: in fact, the first one starts from a value of 3.0% and arrives at 0.4% after 300 years; while the second one starts from 0.7% and reaches 0.3% at the end of the considered time horizon. The result highlights the importance of estimating country-specific dual and declining discount rates. These discount rates allow appropriate weights to be given to all investment impacts, and therefore also to environmental impacts, compared to conventional discounting.