Grandma and Grandpa are sitting alone in their living room in Dubuque, Iowa in February. It is -15° Fahrenheit (-26°C) and they haven’t been truly comfortable in two months. They want a Club Med vacation — to get down to a warm, sunny place for a few weeks — but they are living on Social Security payments.
Their quandary is solved, however, when they realize they can raid their six-year old granddaughter’s college savings account with about $12,000 in it. Great!
The couple books a month-long trip to a sun-drenched, all-included resort vacation — returning just about the time the first glimmers of spring start to appear in the Midwest. Their granddaughter doesn’t care, or even know, about the damage done to her prospects.
While this scenario might seem nuts from a morality standpoint, it is, in fact, perfectly sensible from the standpoint of financial theory.
The fundamental concept of finance is the “Time Value of Money” (TVM), explained simply as “a dollar today is worth more than a dollar tomorrow.” This concept, which has been historically attested to since around 500 CE, implicitly values the life and comfort of people in the present day more than that of those in future periods.
Obviously, the TVM concept starts to break down in extreme cases — Club-Med grandparents and climate change are two perfect examples.
This article is about applying TVM to the topic climate change and the mechanism for doing that — the “discount rate.” It might seem like an arcane, academic topic, but I can say without hyperbole that it is a question that is key to whether human civilization thrives or collapses.
What’s the Right Discount Rate?
The accepted method for converting the value of a future dollar into the present is by using what is known as a “discount rate.” You know about discount rates through the concept of a bank account’s interest rate or the yield on a bond investment. A company wants to borrow $100 in a bond issuance and promises to pay back $105 at the end of the year. In this case, the discount rate is 5%, meaning that you need 5% more future dollars to equal a given quantity of present dollars.
One recipient of the 2018 (fake) Nobel Prize in Economics, Yale University’s William Nordhaus, believes that when considering climate change, we should use a discount rate of 3%. While this rate may not seem very high, looking at a time horizon of 100 years, the standard equation for figuring future values says that it would take about $2,009 in 2119 dollars to equate to just $100 today ($100 * e^(100 years x 3%) = $2,008.55).
The logical conclusion of this finding as it relates to climate change is that it is better to save money today by not embarking on expensive mitigation efforts. If we save money today, we will have a lot more to pour into remediation or adaptation strategies in 100 years. The Club Med Grandparents would approve.
Another giant in this field, Sir Nicholas Stern of the London School of Economics, has a very different opinion about discount rates. In his magisterial 2006 study, Stern Review on the Economics of Climate Change, Professor Stern uses a discount rate of 0.1%.
At this low of a rate, it makes sense to remediate today to counter the future effects of climate change; future dollars are not worth so much more than present ones ($100 in 2019 equals $111 in 2119 at a 0.1% discount rate).
While this approach works better from a climate change remediation standpoint, it flies in the face of the concept of TVM, axiomatic in the economic world for centuries, and also leads to other conceptual problems in the field of resource allocation.
Which of these esteemed gentlemen is correct? Nordhaus’s work has been used as ammunition to take no climate action by enthusiasts of the status quo (mainly employed in the energy industry and ancillary energy-intense industries) even though Nordhaus himself believes humanity needs to act to stave off the “negative externalities” of climate change. Sir Stern’s study raised an enormous amount of discussion when it was published, but lately seems to have very little impact on policy makers’ decisions.
Here is my take:
The “Right” Discount Rate Doesn’t Exist
I do not have a Nobel Prize — fake or otherwise — and I am not an LSE Economist and life peer of the British Empire, but I assure you that both esteemed gentlemen are wrong about discount rates.
While their respective choices of discount rates are different, both make the same fundamental error: conceiving of the long-run socioeconomic environment in terms of continuous, incremental change.
The easiest way to illustrate this error is by looking at the effects of a sudden geographical move.
I am a U.S. citizen and save money in U.S. depository accounts. I understand what a fair rate of interest is to earn on my money. My views about this rate are based on my understanding of the economic conditions of the United States.
If I were to move to South Africa, convert my savings into rand, and deposit those rand into a South African bank, I would not expect the interest rate on my new deposit accounts to be related to the interest rate on my old U.S. deposit accounts. The strengths and weaknesses of the South African economy is completely different from those of the United States.
In this example, I have assumed a sudden move from one national regime to another. I have no expectations for a continuation of American interest rates in South Africa because I understand that the conditions in place in both nations are very different.
In the case of climate change, the discontinuous shift will not be a geographic one but a temporal and environmental one.
Once fecund farmland will fall fallow. Once rich seas will empty of life. Once economically and socially important gateway cities will be forced to be abandoned. The carrying capacity of our land will be reduced. These changes will occur faster than we can presently conceive — as if we suddenly stepped out of one world and into another.
Assuming that there should be a continuity between discount rates under two vastly different ecological regimes is as nonsensical as assuming U.S. demand deposits will pay the same interest as South African ones.
Nordhaus is wrong. Stern is wrong.
Approaching a Tipping Point
Science tells us that complex systems exhibit phenomenally stable conditions until those systems reach certain tipping points. Once those tipping points are breeched, the complex system falls into a different phenomenally stable state. You can read about an excellent example of this effect in this excellent Quanta article about a bass pond in Wisconsin.
A recent study suggests a 93% chance that the earth will see a rise of greater than four degrees Centigrade by 2100 — twice the target level of the Paris Accord and catastrophic under any reasonable definition. In so doing, the climactic system will breech important tipping points and fall into a very stable new regime.
The study’s authors equate the economic effects of such warming to a never-ending Great Depression — never ending because of the stability of the new regime.
Perched at this time in human civilization, you — gentle reader — have the choice of how best to act to build and preserve intergenerational wealth in the 21st century. Facing a 93% chance of catastrophic climate change, are you going to continue betting on the status quo?
It is time to invest in a new paradigm. Intelligent investors take note.
I am an investor interested in public and private companies whose focus is finding ways for human civilization to adapt to climate change. You can find out more about my work at IOI Capital.
A similar version of this article appeared on my site at Forbes.com.