I was recently musing on what the right discount rate was for activities that reduce damage to the environment, and how you enable them, since it clearly isn’t the kind of 5% long term interbank lending rate, or over 10% that most companies would use for investments . I read one academic paper that suggested that on a legal basis it should be zero (see here), and another that came to the same conclusion without recourse to law (see here).
This isn’t just a mental challenge for a bored moment. The implication of the ‘normal’ kinds of corporate investment discount rate … and 10% would be at the very low end of the range that would be rational to use is that investing in the life of the next generation (25 years out) is worth only 8% of the worth of investing in this generation. Two generations out it is almost 200 times less valuable, or as near zero as makes no difference. Even at the 5% interbank rates (that no-one could use for investing in anything with any real uncertainty), we get figures of 29% and 8%. It is these kinds of rates that are natural to be used for real investments, whether to get a benefit or avoid an issue … but put in stark numeric terms of the value of each generation, they simply do not square with how we treat the value of the lives of our children. At an individual and their children level, behaviour that treated the value of children at this tiny level is regarded as reason to put the children into care, and the parent in prison. But, at a total society level, it is normal/rational behaviour!
At a practical level, you can see this play out all over the world. There are many examples of the tragedy of the commons, where a common (and therefore free at the point of use) resource is over-exploited, becoming worthless in a generation or less. You can see heavy investment in gas fired power stations that rely on the use of a very limited (in inter-generational terms) natural resource. You see arguments made from the perspective of the status quo, for example in the difficulty of balancing wind power with usage patterns (true, but makes no allowance of for ingenuity, nor remotely balances against the avoided damage from fossil fuels).
But, the trouble with trying to enable the right discount rate for these kinds of investments is that you get gamed by people who arbitrage the difference between the ‘real’ discount rate, and the environmental discount rate. And, as with all arbitrage opportunities, it will dominate behaviour, especially when the arbitrage gap is as large as it is in the case, over even relatively short time periods. And, you cannot fight the market in any real economy, since the market is worth more than the government, and has vastly less social burden to carry. The market must make this work.
So, that got me wondering what it would take to create reverse arbitrage opportunities, that would allow the self-centred profit maximising power of the market to balance or overtake the positive arbitrage. It is clearly hard, since a little like flow of heat which goes from hot to cold, arbitrage moves in one direction only to close the arbitrage gap. If you try and artificially reverse it, then the market will simply gear up to close the now larger gap … as the UK government found when it tried to bet against the market on alignment with the ERM, so making George Soros a billion dollars (see here).
But, in reality, with the correct environmental discount rate, the arbitrage should be the other way around, and massive. Put another way, how do we get people to aggregate up the real focus we all have on our children and our childrens children, and make it a risk free opportunity that the markets will close? Having pondered it for a week or two, I can’t find a remotely easy route. That isn’t a huge surprise, since if one existed that was in any way obvious or possible today, it would be being used (that being the way that arbitrage in the markets works!). But, the alternative is pretty unappealing, as the stunningly underwhelming progress on climate change avoidance globally has shown.
I have a few thoughts that I’ll put in a separate post, since this is quite long enough already. But, also intrigued to know what ideas others have here. How do we create arbitrage opportunities that entice markets to the behaviour that we all need? Read anything good on this?