Risk attitudes and certainty equivalents: Individuals and other entities are generally not neutral when faced with situations of uncertainty or risk. In most cases related to environment and health they are considered to be risk averse, favoring a certain outcome to one that is uncertain even if the expected value of the risky outcome is equal to the value of the certain one. The theoretically preferred manner of incorporating risk attitudes is to use certainty equivalents sometimes termed certain monetary equivalents Certainty equivalents are defined as the minimum amount that an individual would be willing to accept with certainty instead of facing the uncertain outcomes. 10 While certainty equivalents have theoretic appeal, they are difficult to put into practice for economic analyses of environmental policies. Estimation of certainty equivalents requires detailed knowledge of ( or assumptions about) risk preferences, and analysts are unlikely to have these data. To estimate certainty equivalents one must also be able to assign probabilities to the set of potential outcomes. It is often very difficult or impossible to make these assignments.

Lay and expert risk perceptions: Lay perceptions of risk may differ significantly from scientific assessments of the same risk, and an extensive literature has developed on the topic. 11 Because individuals respond according to their own risk perceptions, it is important for the analyst to be attentive to situations where there is an obvious divergence in these two measures. In such cases, analysts should consider evaluating policy options under both sets of information clearly stating the basis for economic value estimates used or developed in their analysis. Because providing information to the public may reduce differences between lay and expert perceptions of risk, and may allay public concerns, analysts should consider including these strategies in their analysis of potential policy options.

Provision of information: Some policy actions focus on providing information on risks to health and welfare. Inasmuch as this information allows consumers to make better decisions regarding their households' welfare there is an economic benefit to providing this information. Revealed preference benefit analyses, however, can make new information appear to have a net negative effect on household welfare because households may undertake new ( and costly) activities in response. An appropriate framework for evaluating the benefits of information provision under these circumstances is to assess the costs of sub optimal household decisions under the lesscomplete information. 12 Analysts should carefully consider these issues when they evaluate policies that focus on information provision.

29 Chapter 5: Overview 10 Some researchers have suggested risk adjusted discount rates as an alternative device for incorporating information on the uncertainty future benefits and costs. Most economists now conclude, however, that the discount rate should not be adjusted to account for uncertainty in benefit cost analysis.

11 Useful general sources include Slovic ( 1987) and Fischhoff et al. ( 1978).

12 Foster and Just ( 1989) describes this approach more fully, demonstrating that compensating surplus is an appropriate measure of willingness to pay under these conditions. The authors illustrate this with an empirical application to food safety. Quasi option value: Another relevant issue in decision making under uncertainty is that of quasi option value as identified by Arrow and Fisher ( 1974). Some environmental policies involve irreversible decisions that must be made in the face of uncertainty. If information that reduces this uncertainty can be expected to develop over time, then there is a positive " quasioption value to waiting until this information is available In this case, the value originates from possessing the option to hold off on making the decision until uncertainties are resolved. Generally, it is difficult to quantitatively include quasi option values in an economic analysis of environmental policy, but the concept is useful and may be highlighted qualitatively if circumstances warrant. For more on this issue see Freeman ( 1984, 1993), Fisher and Hanemann ( 1987), and Cochrane and Cutler ( 1990).

5.6 Emerging Cross Cutting Issues Many other cross cutting issues are not detailed in the EA Guidelines. Some of these issues are difficult or impossible to incorporate fully into economic analyses at this time, but may become either more important or more tractable as the economic literature develops. Although the relevance of these considerations depends on the specifics of the policy being considered, analysts may want to at least consider these issues qualitatively. Three emerging issues are identified here: tax interaction effects, the pace of exogenous technological change, and the effects of regulation on innovation.

Tax Interaction effects: Although evaluations of environmental policies typically assume a first best regulatory setting, preexisting taxes such as those on labor income create a second best setting. This difference can affect the estimated costs of policy actions. Recent advances in applied general equilibrium analysis have led to generally replicable qualitative results. These studies indicate that ignoring these effects may result in underestimating the cost of compliance from a social perspective. 13 However, the magnitude of the effect   and perhaps the direction   will vary across policies. Although the analytical emphasis on this issue has been on estimating costs, benefits analysis can conceivably suffer a similar bias.

Pace of exogenous technological change: Economic analysis of environmental policies may be affected by the pace of exogenous technological change. In principal, accounting for this can either increase or decrease marginal and total abatement costs, depending on the direction of change. Generally, however, the expectation is that accounting for exogenous technological change would decrease estimated abatement costs. Recent analyses have indicated that even for mature technologies the magnitude of this effect can be large. 14 Regulation and innovation: More extensive research is being developed to examine the impact of various regulatory approaches on firms' research and development decisions for abatement technology. 15 As suggested in the descriptions of alternative regulatory approaches in Chapter 4, this impact may be positive or negative depending on the regulatory approach and setting. Generally, economists expect that incentivebased instruments will provide greater incentive for cost reducing innovations than will command and control regulatory approaches. Policies that provide information to firms and consumers may also affect technological innovation. Chapter 8 provides some additional information on the subject of regulation, innovation, and the implications for estimating social costs.

30 Chapter 5: Overview 13 For an example see Bovenberg and Goulder ( 1997).

14 See, for example, Ellerman and Montero ( 1998) and Carlson et al ( 1998).

15 See, for example, Milliman and Prince ( 1989) and Biglaiser and Horowitz ( 1995). 5.7 References Arnold, F. S. 1995. Economic Analysis of Environmental Policy and Regulation. New York, NY: John Wiley and Sons, Inc.

Arrow, K. J. and A. C. Fisher. 1974. Environmental Preservation, Uncertainty and Irreversibility, Quarterly Journal of Economics, 88( 1): 1 9.

Biglaiser, G. and J. K. Horowitz. 1995. Pollution Regulation and Incentives for Pollution Control Research, Journal of Environmental Economics and Management, 3( 4): 663 684.

Bovenberg, A. L. and L. H. Goulder. 1997. Costs of Environmentally Motivated Taxes in the Presence of Other Taxes: General Equilibrium Analyses, National Tax Journal, 50( 1): 59 87.

Carlson, C., D. Burtraw, M. Cropper, K. L. Palmer. 1998. Sulfur Dioxide Control by Electric Utilities: What are the Gains from Trade? Resources for the Future, Discussion Paper 98 44.

Cochrane, H. and H. Cutler. 1990. The Economics of Sequential Choice Applied to Quasi Option Value, Journal of Environmental Economics and Management, 18( 3): 238 246.

Ellerman, A. D. and J. P. Montero. 1998. The Declining Trend in Sulfur Dioxide Emissions: Implications for Allowance Prices. Journal of Environmental Economics and Management. 36( 1): 26 45.

Fischhoff, B. et al. 1978. How Safe is Safe Enough? A Psychometric Study of Attitudes Towards Technological Risks and Benefits. Policy Sciences 9: 127 152.

Fisher, A. C and W. M. Hanemann. 1987. Quasi Option Value: Some Misconceptions Dispelled, Journal of Environmental Economics and Management, 14( 2): 183 190.

Foster, W. and R. E. Just. 1989. Measuring Welfare Effects of Product Contamination with Consumer Uncertainty. Journal of Environmental Economics and Management, 17: 266 283.

Freeman, A. M. III. 1984. The Quasi Option Value of Irreversible Development, Journal of Environmental Economics and Management, 11( 3): 292 295.

Freeman, A. M. III. 1993. The Measurement of Environmental and Resource Values: Theory and Methods. Resources for the Future, Washington, D. C.

Knight, F. H. 1921. Risk, Uncertainty, and Profit. Boston, MA: Houghton, Mifflin Co.

Milliman, S. R. and R. Price. 1989. Firm Incentives to Promote Technological Change in Pollution Control, Journal of Environmental Economics and Management, 17( 3): 247 265.

Morgan, M. G. and M. Henrion. 1990. Uncertainty: A Guide to Dealing with Uncertainty in Quantitative Risk and Policy Analysis. New York, NY: Cambridge University Press.

Slovic, P. 1987. Perception of Risk. Science, 30( 4): 423 439.

U. S. Environmental Protection Agency. 1985. Costs and Benefits of Reducing Lead in Gasoline: Final Regulatory Impact Analysis. EPA/ 230/ 05 85 006, Office of Policy Analysis, February 1985.

U. S. Environmental Protection Agency. 1997. Economic Analysis for the National Emissions Standards for Hazardous Air Pollutants ( NESHAPS) for Source Category; Pulp and Paper Production; Effluent Guidelines, Pretreatment Standards, and New Source Performance Standards: Pulp, Paper and Paperboard Category  Phase 1. EPA/ 821/ R 97/ 012, Office of Water, October 1997.

31 Chapter 5: Overview 32 Chapter 5: Overview 6.1 Introduction The costs and benefits of many environmental policies are frequently paid and received at different points over the course of sometimes long time horizons As a result, benefit cost and related analyses that are key components of EPA's policy development and evaluation process must describe future effects in terms that help present day policy makers choose appropriate approaches for environmental protection.

One common method for doing so is called discounting which is the process whereby the values of future effects are adjusted to render them comparable to the values placed on current consumption, costs, and benefits, reflecting the fact that a given amount of future consumption is worth less than the same amount of consumption today. Time discounting is accomplished by multiplying the future values of a policy's effects by discount factors that reflect both the amount of time between the present and the point at which these events occur and the degree to which current consumption is more highly valued than future consumption.

Despite the relative simplicity of the discounting concept choosing a discount rate has been one of the most contentious and controversial aspects of EPA's economic analyses of environmental policies. While there are several plausible explanations for why discounting in environmental policy evaluation has been unsettled for many years, the most important is that the theoretical and applied economics literature on discounting from a social perspective is voluminous and technically complex. This makes it difficult to distill precise advice on appropriate discounting procedures for policy analysis. Moreover, in some cases the economics literature by itself does not yield simple and robust discounting rules for practical applications because making such important social decisions requires inputs from disciplines other than economics.

Nonetheless, it is important to consider the uncertainties surrounding social discounting in the broader context of applied economic analysis. Benefit cost analysis is not a precise tool that yields firm numerical results, rather, it is a general framework for more carefully accounting for the potential and varied effects of government programs. Some of these effects can be quantified, whereas others can only be assessed qualitatively. Some may be relatively certain whereas others may be quite speculative.

The imprecision connected with assessing benefits and costs suggests that the controversy surrounding the discount rate, in many circumstances, may have more theoretical than practical significance. For example, the effects on net benefits of alternative assumptions made for measuring and valuing uncertain effects of environmental policies can overwhelm the effects of changes in the discount rate. Additionally, for some government projects, benefits and costs may have similar time profiles, or benefits may so outweigh costs ( or vice versa), that changes in the discount rate will not influence the policy implications of the analysis.

This review of the basics of social discounting begins in Section 6.2 with a discussion of some general considerations in social discounting. In Section 6.3, various discounting procedures for environmental policy assessment are presented and evaluated. This detailed discussion is divided into social discounting as applied in intra generational contexts, where very long time horizons involving multiple generations do not apply, and discounting for inter generational 33 Chapter 6 Chapter 6: Analysis of Social Discounting circumstances involving long time horizons and unborn generations. EPA guidance for intra generational social discounting is presented in Section <IP_ADDRESS>. EPA guidance on inter generational social discounting follows in Section <IP_ADDRESS>. Finally, discounting and related procedures for situations in which some effects are not monetized are addressed in Section 6.4.

6.2 General Considerations in Social Discounting This section reviews a few basic concepts and considerations central to understanding the role and importance of discounting in public policy evaluation. The focus is mainly on describing social discounting and on distinguishing discounting per se from other aspects of measuring and summarizing the costs, benefits, impacts, and other consequences of environmental policies. It also discusses the circumstances in which discounting has a large impact on the net social benefits of an environmental policy.

6.2.1 Social and Private Discounting Discounting in public policy evaluation is normally referred to as social discounting or discounting using the social rate of interest. The process itself   applying discount factors to future flows of costs, benefits, and other consequences of environmental and other policies   is mechanically the same as the discounting process in private individuals' economic and financial calculations. What makes it " social" discounting is that it is being applied in the context of evaluating a policy's effects from an overall social perspective. Clearly, private and social perspectives can yield very different conclusions concerning for example, the cost of engaging in an activity that also generates environmental harms.

Whether social discounting also departs significantly from private discounting, however, is less clear. Some approaches to social discounting suggest that the procedures and rates should be the same as those used in private sector discounting. Other perspectives, however, suggest that social discounting is a very different process than a single individual's discounting. In any event, at a minimum the term " social discounting" refers to the broad society as a whole point of view embodied in benefit cost and other analyses of public policies. Whether it also connotes procedures and rates different from private discounting is a central question explored in this chapter.

6.2.2 Methods for Summarizing Present and Future Costs and Benefits Most applications of social discounting in environmental policy evaluation involve translating future values into present ones. The conceptual foundation of discounting is based on the fact that present consumption is valued differently from future consumption. Discounting renders costs and benefits that occur in different time periods comparable by stating them all in present day terms. The resulting net present value is at least one measure of social value that might be used in evaluating environmental policies.

<IP_ADDRESS> Net Present Value In formal terms, the net present value of a projected stream of current and future benefits and costs is found by multiplying the benefits and costs in each year by a timedependent weight, dt, and adding all of the weighted values as follows:

NPV = NB0 + d1NB1 + d2NB2 + ... + dnNBn NBt is the net difference between benefits and costs ( Bt Ct) that accrue at the end of period, t, and the discounting weights are given by:

dt = l/( l+ r) t where r is the discount rate and n is the final period in the future in which the policy's effects are felt.

To account for inflation, either real or nominal values may be used, as long as they are used consistently. In other words, nominal costs and benefits require nominal discount rates, and real costs and benefits require real discount rates. Moreover, consistent decision making requires that the same discount rate be used for both 34 Chapter 6: Social Discounting benefits and costs. Otherwise, any policy can be justified by choosing a sufficiently low discount rate for benefits, by choosing a sufficiently high discount rates for costs, or by choosing a sufficiently long time horizon.

It is important to be explicit about how time periods are designated and when, within each time period, costs and benefits accrue. Typically, time periods are years, but alternative time periods may prove desirable or necessary if costs or benefits accrue at irregular or non annual intervals The preceding formula assumes that t= 0 designates the beginning of the first period. Therefore, C0 represents startup costs such as capital costs that occur immediately upon implementation of the regulation. The formula further assumes that no additional costs are incurred until the end of the first year of regulatory compliance. 1 Benefits, if any, also accrue at the end of each time period. Therefore, the following diagram illustrates how net benefits ( measured in dollars) are distributed over time.

<IP_ADDRESS> Annualized Values In addition to net present value, there are other procedures for rendering costs and benefits that occur in more than one time period comparable. One method is to annualize the costs and benefits over the duration of the policy. For example, in the absence of discount rates ( r= 0), a regulation that costs $ 100,000 at the end of the first year, $ 200,000 at the end of the second year, and $ 300,000 at the end of the third year can be said to cost $ 200,000 a year in annualized costs over the three year period. Comparing annualized costs to annualized benefits is equivalent to comparing the present values of costs and benefits.

Costs and benefits each may be annualized separately by using a two step procedure. To annualize the costs, for example, the present value of costs is calculated using the NPV formula in Section <IP_ADDRESS>, except that the stream of costs alone, not the net benefits, is used in the calculation. This present value is then annualized ( as in calculating mortgage payments) according to the following formula:

where,

AC = annualized cost accrued at the end of each of n periods;

PVC = present value of costs;

r = the discount rate per period; and n = the duration of the policy.

Note that the annualized cost is the amount one would have to pay at the end of each period t to add up to the same cost in present value terms as the stream of costs being annualized. There is no initial cost at t= 0 in this annualization. Such an initial cost can be incorporated into the annualization using the slightly different formula:

This approach is also useful when analyzing non monetized benefits, such as reductions in emissions or reductions in health risks, when benefits are constant over time. The average cost effectiveness of a policy can be calculated by dividing the annualized cost by the annual benefit to produce measures of program effectiveness, such as the cost per ton of emissions avoided.

<IP_ADDRESS> Net Future Value Finally, there is yet another way of rendering costs and benefits that occur in more than one time period comparable Instead of discounting all future values back to the present, it is possible to accumulate them forward to some future time period   for example, to the end of the last year of the policy's effects, n. Here, the net benefit test is whether the accumulated net future value ( NFV) is positive.

NFV = d0NB0 + d1NB1 + d2NB2 + ... + dn 1NBn 1 + NBn 35 Chapter 6: Social Discounting 1 See EPA ( 1995) for an example in which operating and monitoring costs were assumed to be spread out evenly throughout each year of compliance. While the exponential function above is the most accurate way of modeling the relationship between present value and a continuous stream of benefits and costs, simple adjustments to the equations above can sometimes adapt them for use under alternative assumptions about how dollar flows are distributed over time. TIME Year t 0 1 2 3 4 ... n $ NB0 NB1 NB2 NB3 NB4 ... NBn AC = PVC × r × ( 1 + r) n ( 1+ r) n  1 AC = PVC × r × ( 1 + r) n ( 1+ r)( n+ 1)  1 Chapter 6: Social Discounting 36 NBt is the net difference between benefits and costs ( Bt Ct) that accrue in year t and the accumulation weights, dt, are given by dt = ( l+ r)( n t)

where r is the discount rate.

Each of these methods employs an interest rate to translate values through or across time, so the methods are not really different ways to determine the benefits and costs of a policy. Instead, they are different ways to express and compare costs and benefits that occur in multiple time periods on a consistent basis. Discounting places all costs and benefits in the present time period, annualization spreads them smoothly through time, and accumulation states them all in the future. But each procedure uses the same discount ( interest) rate, so they are different ways to describe the same underlying phenomenon.

Depending on the circumstances, one method might have advantages over the others. For example, annualizing the costs of two machines with different service lifetimes might reveal that the one with the higher total cost actually has a lower annual cost because of its longer lifetime. Similarly, discounting to the present is likely to be the most informative procedure when analyzing a policy that requires an immediate investment and offers a stream of highly variable future benefits.

In general, however, these are alternative ways of translating costs and benefits through time using an interest rate. Therefore, the analysis, discussion, and conclusions presented in this chapter apply to all methods of translating costs, benefits, and effects through time, even though the focus is mostly on discounting.

6.2.3 Sensitivity of Present Value Estimates to the Discount Rate The impact of discounting streams of costs and benefits in public policy evaluation is sometimes large and sometimes not, depending on the circumstances. When all effects occur in the same period, discounting may be unnecessary or superfluous: net benefits are positive or negative regardless of the discount rate used or the procedure for translating them through time. Similarly, when costs and benefits of a policy are largely constant over the relevant time frame, discounting costs and benefits will produce the same conclusion concerning the policy as would examination of a single year's costs and benefits. Of course, higher discount rates will reduce the present value of any future cost or benefit. But if costs and benefits of a policy occur simultaneously and if their relative values do not change over time, whether the net present value of such a policy is positive does not depend on the discount rate.

Discounting can substantially affect the present value net benefits estimates for public policies when there is a significant difference in the timing of costs and benefits. For example, if the costs of a policy are incurred today, they are not discounted at all. But if the benefits will occur 30 years from now, the present value of the benefits, and, hence, the net present value of the policy's effects, depends critically on the discount rate used.

Suppose the cost of some environmental policy that is incurred entirely in the present is $ 1 billion and that after 30 years a benefit results that is estimated to be worth $ 5 billion in the future. Without discounting, a policy that offers benefits five times its cost appears to be a very worthwhile social investment. Discounting the $ 5 billion future benefits, however, can radically alter the economic assessment of the net present value of the policy. Five billion dollars, 30 years in the future, discounted at one percent is $ 3.71 billion, at three percent it is worth $ 2.06 billion at seven percent it is worth $ 657 million, and at 10 percent it is worth only $ 287 million. In this case, the range of discount rates generates over an order of magnitude difference in the present value of benefits. And, longer time horizons will produce even more dramatic effects on a policy's net present value. Hence, the choice of the discount rate largely determines whether this policy is considered, at least on economic efficiency grounds, to offer society positive or negative net benefits.

Thus, for government projects and policies that require large initial outlays or that have long delays before benefits are realized, the selection of the discount rate can be a major factor in determining whether the net present value is positive. Many of EPA's policies fit these profiles. Large investments by public or private parties are usually required early on, whereas the benefits of those investments either accrue for many years thereafter, such as improvements in health and environmental quality, or will not begin for many years, such as reductions in the contamination of environmental systems from hazardous waste, landfill facilities, and the protection of the earth's atmosphere and climate.

6.2.4 Distinguishing Discounting from Other Procedures Discounting is only one of several components that are necessary in order to produce comparable estimates of a policy's costs and benefits that accrue over more than one time period. Discounting is a technique for translating values from one time period to another in order to express the values of a policy's consequences in consistent terms. It is not, however, a method for actually determining the future values of future costs and benefits. Two considerations related to determining these future values   projecting future values based on present ones and accounting for risk   are closely related to discounting.

<IP_ADDRESS> Future Values of Costs and Benefits The future value of one of an environmental policy's effects may hinge critically on the assumed rate of growth of wealth over time. There may also be a connection between increasing wealth and the discount rate for expressing future values in present day terms. Nevertheless, the process of determining the values of future costs and benefits and then translating them into present terms are two conceptually distinct procedures.

It is generally appropriate to conduct each of these tasks separately. And, it is prudent to avoid attempting to " correct for errors in one procedure by " adjusting" the other. For example, it is technically possible to use a current valuation for a future benefit whose future value is expected to increase, but then reduce the discount rate to reflect that assumed rising valuation through time. Nevertheless, this is usually unwise because the values of other consequences of a policy might not follow the same rate of increase over time. Thus, these might be over or undercorrected by the adjusted discount rate. The only way to avoid that result would be to use a different adjusted discount rate for each cost and benefit stream, which is generally inappropriate.

<IP_ADDRESS> Risk and the Social Discount Rate The relationship between risk and the rate of return on assets has been an important subject in modern finance. Risk considerations also have played a role in the controversy surrounding the selection of an appropriate discount rate for benefit cost analysis. For example, one recommendation is that public projects with risky or uncertain future costs and benefits should be discounted at a higher rate reflecting those risks, just as it is in the private sector.

The concept of risk is often interpreted narrowly as being measured by the variability or range of possible outcomes of a project. Greater variation implies more risk according to this view. But the notion of risk should be conceptualized more broadly. Rather than being taken in isolation, the risk of a project is measured by its effect on the variability in outcomes of the entire portfolio of assets. In general, the degree of risk associated with an asset is measured in terms of the covariance of its returns with those of the portfolio of assets to which it is added. 2 When viewed from this broader perspective, most environmental projects are either riskless or reduce risk. This is because most environmental projects have benefits and costs that are widely dispersed and that are uncorrelated or negatively correlated with future measured income and other aspects of economic welfare.

Nevertheless, the costs and benefits of some environmental policies can be risky in this broader sense. In these cases, it is commonly argued that the discount rate should be adjusted upward by a risk premium to value future uncertain returns. However, this is generally not the correct procedure because it requires the discount rate to reflect both the risk of future returns as well as the length of time until they materialize. That is, if the goal is to reduce the present value of a project's returns to reflect their risk, the same decrease in present value will be 37 Chapter 6: Social Discounting 2 An assumption underlying this analysis is that the asset being acquired is a very small fraction of the portfolio of assets already held. If this assumption is violated, the variability in returns of the asset can directly affect the variability of returns to the entire portfolio. The potential costs and benefits of environmental policies generally are spread among large numbers of people, however, which satisfies the condition that the asset acquired be a small portion of the portfolio of assets already held. produced by a smaller increase in the discount rate the longer the delay until the returns are received. 3 Economic theory suggests using two different " instruments to accomplish the two different goals. One such procedure to account for risk is to value a project's uncertain returns using the certain monetary equivalent or certainty equivalent. As discussed in Chapter 5 of this document, this is the amount risk averse individuals would be willing to pay with certainty for the risky prospect. The certainty equivalent should then be discounted using the rate of interest individuals use to discount other perfectly certain flows.

Hence, to properly account for risk in benefit cost analyses the first step should be to evaluate whether a project is actually risky from the broader perspective of society's larger portfolio of assets. Many government policies are not risky at all, so that their expected values of costs and benefits can be discounted directly using a risk free interest rate. For projects that offer truly risky prospects, however certain monetary equivalents for these returns should be derived and then discounted to the present using a risk free rate. The discount rate should not be " adjusted" to account for risky costs and benefits.

6.3 Approaches to Social Discounting This review of the basics of social discounting and the new EPA guidance on the subject begins with discounting in conventional or intra generational contexts, where very long time horizons involving multiple generations do not apply. Next, approaches for inter generational social discounting involving very long time horizons and unborn generations, are presented and evaluated.

The main purpose of this discussion is to provide a broad overview of the extensive literature on social discounting in order to distill from it practical guidelines for environmental policy evaluation. It is not, however, a detailed review of the literature on discounting in public project evaluation which is vast in scope and volume. Excellent sources for summaries of the social discounting literature are Lind ( 1982a), Lind ( 1982b), Lind ( 1990), Lind ( 1994), Lyon ( 1990), Lyon ( 1994), Kolb and Scheraga ( 1990), Scheraga ( 1990), IPCC ( 1996), Pearce and Turner ( 1990), and Pearce and Ulph ( 1994).

6.3.1 Intra Generational Social Discounting This section explores social discounting in conventional or intra generational contexts, specifically those in which very long time horizon issues are not important features. Most of the traditional discounting literature focuses on these circumstances. Intra generational contexts may well have decades long time frames, but they do not explicitly confront the extremely long time horizons and impacts on unborn generations that are central to the extensions of social discounting research into climate change, nuclear waste disposal, and other such policy issues. The division of the problem into intra generational and inter generational social discounting helps to understand the substantially different contribution economic approaches can offer in each area.

The discussion begins with a brief review of the analytical foundations of conventional social discounting. It next outlines the major social discounting approaches suggested in the literature. The section concludes with a review of the concrete conclusions and advice offered by the traditional discounting literature and the new guidance developed by EPA for use in social discounting in intra generational contexts.

<IP_ADDRESS> Analytical Foundation of Intra Generational Social Discounting Conventional social discounting is rooted firmly in the view that the government is acting on behalf of its citizens in undertaking public projects and promulgating environmental and other policies. Therefore, benefit cost analysis of these actions should seek to estimate the costs and benefits experienced by all of the affected parties, and in so 38 Chapter 6: Social Discounting 3 Note that if discount rates are adjusted to incorporate risk, the adjustment is not always upward. Risky benefits are worth less than their expected value, so an upward adjustment of the discount rate will reduce the present value. But uncertain costs would require a downward adjustment of the discount rate to increase the present value to reflect the fact that risk averse individuals would pay more than the expected value of the costs to avoid bearing the uncertain prospect. doing determine whether, in aggregate, the gainers under a policy would be able to compensate the losers.

This foundation for social discounting has an important implication for the choice of a social discounting method. Just as consumer sovereignty dictates that the government should incorporate the specific values that particular individuals place on outcomes that affect them in assessing its actions, the government should also discount future costs and benefits in the same way that the affected individuals do. Strict adherence to the principles of consumer sovereignty is necessary in order to determine how much each person would agree he or she is made better or worse off by a given policy in present value terms.

The analytical and ethical foundation of the intra generational social discounting literature thus rests on the traditional test of a " potential" Pareto improvement in social welfare   whether gainers could compensate the losers. This framework fundamentally casts the consequences of government policies in terms of collections of individuals contemplating changes in their own consumption ( broadly defined) over time. Thus, social discounting in this context should seek to mimic the discounting practices of the affected individuals.

The Paretian economics point of view, however, is not the only ethical perspective possible in this context. As discussed in the section on inter generational discounting, another approach is to cast the problem in terms of maximizing a social welfare function that includes utilities of present and future individuals and is maximized according to an alternative set of objectives and constraints. While alternative social welfare functions could apply to intragenerational circumstances, it is generally confined to inter generational contexts. Hence, although there is nothing inherent in a short time horizon policy that dictates that only the Paretian perspective is appropriate for intragenerational situations, this is the most commonly accepted point of departure in the social discounting literature for these circumstances. It is also worth considering the two very distinct foundations for social discounting separately because their implications for determining the social discount rate are quite different. The Paretian economic approach suggests that the social discount rate is to be found by examining the preferences of affected parties, while the discount rate under alternative social welfare functions is not necessarily based on the preferences of existing individuals. 4 <IP_ADDRESS> Fundamental Procedures for Intra Generational Social Discounting Given the reasonably precise and circumscribed objective of social discounting as described above, the volume of literature on the topic is surprisingly diverse and complex. This section briefly reviews the major approaches suggested in the literature and evaluates their implications for practical social discounting in environmental policy assessments The section concludes with a summary of recommended practices for social discounting in intra generational contexts.

Consumption Rate of Interest Approach for Social Discounting The economic literature begins by pointing out that under a variety of restrictive assumptions   no taxes, no risk, perfect capital markets   the task of discounting effects experienced by individuals would be straightforward. Analysts should simply use the observable market rate of interest that underlies the intertemporal consumption allocation decisions of those same individuals. The rate at which individuals are willing to exchange consumption over time is normally referred to as the " consumption rate of interest."

The simplifying assumptions ( especially the absence of taxes on investment returns) imply that the consumption rate of interest equals the market interest rate, which also equals the rate of return on private sector investments. In this case, individuals discount future consumption at the market rate of interest, which is also the rate at which consumption can be translated through time via private sector investments. Hence, if the government seeks to value costs and benefits in present day terms in the same way as the affected individuals, it also should discount using the market rate of interest.

One of the simplifying assumptions underlying this result   that the consumption rate of investment at which consumers discount future consumption equals the rate of 39 Chapter 6: Social Discounting 4 This concept is also treated in Chapter 10 in the discussion of ways to jointly consider efficiency and equity within a single analytical framework. return on private sector investment   probably does not hold in practice. Taxes on private sector investment returns can cause the social rate at which consumption can be traded through time ( the pre tax rate of return) to exceed the rate at which individuals can trade consumption over time ( the post tax consumption rate of interest).

For example, suppose the market rate of interest, net of inflation, is five percent, and that taxes on capital income amount to 40 percent of the net return. In this case, private investments will yield five percent, of which two percent is paid in taxes to the government, with individuals receiving the remaining three percent. From a social perspective consumption can be traded from the present to the future at a rate of five percent. But individuals effectively trade consumption through time at a rate of three percent because they owe taxes on investment earnings. As a result, the consumption rate of interest is three percent which is substantially less than the five percent social rate of return on private sector investments ( also known as the social opportunity cost of private capital).

Over several decades, a very large body of economic literature developed, analyzing the implications for social discounting of divergences between the consumption rate of interest and the social rate of return on private sector investment. The dominant approaches in this literature are briefly outlined here.

Consumption Rate of Interest Shadow Price of Capital: The Traditional View One approach that enjoys widespread support among economists recommends that social discounting in intragenerational contexts should use the consumption rate of interest to discount future costs and benefits that have been valued in terms of future consumption. Intuitively, this procedure makes sense because the government is assumed to be valuing future consequences of its policies just as the affected citizens would. If individuals discount future consumption ( and the costs and benefits of a public policy) using the consumption rate of interest, then so should the government. So, the social rate of discount should equal the consumption rate of interest.

But, if the costs of financing a public project or the costs of regulatory compliance displace private investments, society loses the total pre tax returns from those foregone investments Private capital investments might be displaced if, for example, public projects are financed with government debt and the supply of investment capital is relatively fixed. This is the " closed economy" condition. In this case, discounting costs and benefits using the consumption rate of interest ( the post tax rate of interest) does not seem to capture the fact that society loses the higher, social ( pretax rate of return on foregone investments.

Under the consumption rate of interest shadow price of capital approach for social discounting, the social value of displacing private capital investments is taken into account prior to discounting. Under this approach, when a public project displaces private sector investments, the correct method for measuring the social costs and benefits requires an adjustment of the estimated costs ( and perhaps benefits as well) prior to discounting using the consumption rate of interest. This adjustment factor is referred to as the " shadow price of capital." 5 The shadow ( social) price ( value) of private capital is intended to capture the fact that a unit of private capital produces a stream of social returns at a rate greater than the rate at which they are discounted by individuals. If the social rate of discount is the consumption rate of interest, then the social value of a $ 1 private sector investment will be greater than $ 1. The investment produces a rate of return for its owners equal to the post tax consumption rate of interest, plus a stream of tax revenues ( considered to be consumption) for the government.

To illustrate this simply, suppose that the consumption rate of interest is three percent, that the pre tax rate of return on private investments is five percent, that the netof tax earnings from these investments are consumed in each period, and that the investment exists in perpetuity ( amortization payments from the gross returns of the investment are devoted to preserving the value of the capital intact). A $ 1 private investment with these characteristics will produce a stream of private consumption of $ 0.03 per year and tax revenues of $ 0.02 per year. Discounting the private post tax stream of consumption at the three percent consumption rate of interest yields a present value of $ 1. Discounting the stream of tax revenues at the same rate yields a present value of about $ 0.67. The social value 40 Chapter 6: Social Discounting 5 Lind ( 1982a) remains the seminal source for this approach in the social discounting literature. of this $ 1 private investment   the shadow price of capital   is thus $ 1.67, substantially greater than the $ 1 private value that individuals place on it.

Therefore, if financing a public project displaces private investments, this " consumption rate of interest shadow price of capital" approach suggests adjusting the project's costs upward by the shadow price of capital and then discounting all costs and benefits using a social rate of discount equal to the consumption rate of interest. To apply this approach, the first step is to determine whether private investment flows will be altered by a policy. Typically, project costs are thought to displace private capital, at least in part, although project benefits could encourage additional private sector investments. Next, all of the altered private investment flows ( positive and negative) are multiplied by the shadow price of capital to convert them into consumption equivalent units. All flows of consumption and consumption equivalents are then discounted using the consumption rate of interest.

A simple example of this method is as follows. Suppose the pre tax rate of return from private investments is five percent and the post tax rate is three percent, with the difference attributable to taxation of capital income. Assume as well that increases in government debt displace private investments dollar for dollar, and that increased taxes reduce individuals' current consumption also on a onefor one basis. 6 Finally, assume that the $ 1 current cost of a public project is financed 75 percent with government debt and 25 percent with current taxes and that this project produces a benefit 40 years from now that is estimated to be worth $ 5 in the future.

Using the consumption rate of interest shadow price of capital approach, first multiply 75 percent of the $ 1 current cost ( which is the amount of displaced private investment by the shadow price of capital ( assume this is the $ 1.67 figure from above). This yields $ 1.2525, to which is added the $ 0.25 amount by which the project's costs displace current consumption. The total social cost is therefore $ 1.5025. This results in a net social present value of about $ 0.03, which is the present value of the future $ 5 benefit discounted at the three percent consumption rate of interest ($ 1.5328) minus the $ 1.5025 social cost.

Thus, under the consumption rate of interest shadow price of capital approach, costs are adjusted upward to reflect the higher social costs of displacing private investments, but discounting for time itself is accomplished using the consumption rate of interest   consistent with how individuals trade and value consumption over time.

Variants of this approach exist. For example, the Kolb Scheraga ( 1988) approach recommends annualizing capital expenditures using the pre tax rate and then discounting all cost and benefits using the consumption rate of interest.

Other Social Discounting Approaches Other approaches for social discounting in the literature have been recommended on and off over the years. These alternatives focus on different methods than the shadow price of capital approach for evaluating policies that displace private sector investments. However, the procedures these approaches use will not generally produce a correct estimate of the social present value of a policy's costs and benefits. Some of these other methods for social discounting are reviewed and evaluated below.

Weighted average of pre and post tax rates of return: A major alternative approach for addressing the divergence between the higher social rate of return on private investments and lower consumption rate of interest is to set the discount rate for public projects equal to a weighted average of the two. The weights would equal the proportions of project financing that displace private investment and consumption, respectively. Intuitively, this approach would set an overall project discount according to the amount lost by displacing consumption ( using the lower consumption rate of interest) and the amount lost by displacing investments ( using the higher social rate of return on private capital).

For example, suppose the social rate of return from private investments is five percent and the consumption rate of interest is three percent, as above. Suppose further that 75 percent of a public project's costs are financed using 41 Chapter 6: Social Discounting 6 The assumption that additional government borrowing crowds out private investment dollar for dollar is not critical to the example. If crowding out is less than dollar for dollar, then the 75 percent of the project's cost that is financed by additional debt would be further divided into the proportion of that percentage of the cost that displaces private investment, which should then be adjusted using the shadow price of capital, and the remainder of the cost, which is drawn from consumption and therefore does not need to be adjusted. government debt, with the remaining 25 percent of the costs raised through taxation. Finally, assume that government debt crowds out private investment on a dollar for dollar basis and that increased taxes reduce individuals' current consumption also on a one for one basis. The weighted average approach then suggests that the social rate of discount should be 75 percent of five percent plus 25 percent of three percent, or four and a half percent. If the proportions of the project's financing from each revenue source were reversed, however, the weighted average discount rate would instead be 25 percent of five percent plus 75 percent of three percent, or three and a half percent.

This approach has enjoyed considerable popularity over the years, and is probably acceptable for similarly timed cost and benefit flows. 7 As presented above, however, it is technically incorrect and can produce net present value results substantially different from the correct result ( where " correct" is defined by the consumption rate of interest shadow price of capital approach). The problem with the simple weighted average approach is that it seeks to accomplish two tasks using the social discount rate   pure time discounting and adjusting for the displacement of private investments that yield pre tax social returns higher than the consumption rate of interest.

In general, the " synthesized" discount rate based on the social rate of return from private investments and the consumption rate of interest that accomplishes both objectives   and so arrives the correct present value   depends on the timing of the cost and benefits flows. A simple weighted average based only on project cost components will not in general produce the correct result.

To understand this, consider how the weighted average discount rate approach performs for the simple numerical example discussed above. Assume that the social rate of return on private investments is five percent, that the consumption rate of interest is three percent, that increases in government debt displace private investments dollar fordollar that the $ 1 current cost of a public project is financed 75 percent with government debt and 25 percent with current taxes, and that the project produces a benefit 40 years from now that is estimated to be worth $ 5 in the future.

The weighted average social discount rate approach would suggest discounting the future benefit at a four and a half percent rate ( 0.75 times five percent plus 0.25 times three percent). This produces an estimated net social present value of $ 0.14, which is the present value of the future $ 5 benefit discounted using a four and a half percent rate ($ 0.86) minus the current year $ 1 cost. In this case, the weighted average social discount rate approach suggests that the project's net social present value is negative. But earlier, the consumption rate of interest shadow price of capital approach was applied to exactly this scenario, concluding that the net social present value is positive.

The problem with the weighted average approach is that its method for accounting for the higher social cost of displaced private investments is to " over discount" the benefits But the amount of " over discounting" necessary in this example to adjust for the actual social costs of the project's costs depends on the time profile of the benefit stream   the farther in the future the benefits occur, the less " over discounting" is needed. The source of the project's financing is therefore insufficient to define a single rate of social discount that will produce correct net social present value results for any given policy.

Accordingly, to derive the weighted average discount rate that will produce the correct net present value requires that the consumption rate of interest shadow price of capital method be used first to compute the net present value. The discount rate that produces this correct present value based on discounting costs and benefits, but not adjusting for the shadow price of capital, can then be calculated. There seems to be little purpose to this exercise because it requires the net present value of a policy to be computed using accurate procedures first before the adjusted discount rate can be derived.

Opportunity cost of capital: Another approach for social discounting argues that the government should not invest ( or compel investment through its policies) in any project that offers a rate of return less than the social rate of return on private investments. Stated another way, because the citizens collectively enjoy the benefits of all 42 Chapter 6: Social Discounting 7 Lind ( 1982b) provides a clear exposition of the weighted average approach for estimating the social discount rate. The large literature on this topic, spanning the 1960s through the early 1980s, has been summarized well by Lind and others. public and private investments, welfare will be higher overall if the government invests in projects with the highest rates of return. 8 Critics of this social investment rule argue that the government cannot realistically tax citizens and then invest in private sector projects. Therefore, the issue is not what " could" be done with the funds, but rather what " would" be done with them. Thus, if the government obtains funds for a project through taxation and this displaces only private consumption, then relative to consuming the resources today, welfare is increased as long as the project generates future benefits that exceed those costs when discounted at the consumption rate of interest. Of course, it remains true that welfare would be further increased if the funds were devoted to an even more valuable project.

A closely related opportunity cost based observation is that the government faces a menu of projects and, for whatever reason, is not able to undertake all projects that have positive net social benefits when computed using a social rate of discount equal to the consumption rate of interest. In this event, the opportunity costs of funding one program are the benefits of other programs not funded. Proponents of this view typically conclude that the " hurdle discount rate for a particular project should be equal to the rate of return offered by other projects foregone.

Regardless of the particular point of departure, the central point of the opportunity cost strand of the social discounting literature is valid. Social welfare will be improved if the government invests in projects that have higher values than if it invests in lower value ones. Hence, if the net present value of benefits of all courses of action are examined using the consumption rate of interest and the set with the highest net benefits are pursued, social welfare will be higher than otherwise. 9 So stated, this advice is correct.

However, it does not follow that rates of return offered by alternative private or public projects define the level of the social discount rate. An alternative project might produce large benefits over the future and thus offer a large " rate of return." But if individuals discount these future benefits using the consumption rate of interest, the correct way to describe this project is that it offers substantial present value net benefits. In general, the opportunity cost argument is not about the social discount rate per se, but about correctly and consistently examining the social values of all alternatives. As was the case for the shadow price of capital, an alternative project with a high rate of return will have a high social net present value. But this does not imply that its rate of return should become the social rate of discount to be used for pure time discounting for other projects.

Consumption Rate of Interest Shadow Price of Capital: The New View Over the years, the consumption rate of interest shadow price of capital approach to social discounting has gained increasingly wide acceptance among economists. Recently, however, a key assumption in that analysis has been questioned   the assumption that the economy is " closed" to foreign capital flows   and an alternative hypothesis concerning government crowding out of private investment has been put forward. 10 According to this new view, earlier analyses implicitly assumed that capital flows into the nation were either nonexistent or very insensitive to interest rates, a " closed economy" assumption. Empirical evidence suggests, however, that international capital flows are quite large and very sensitive to interest rate changes. In this case, the supply of investment funds to the U. S. equity and debt markets is likely to be highly elastic ( the " open economy" condition) and, thus, private capital displacement is much less important than it was previously thought to be.

Under this new view, it is inappropriate to assume that financing a public project through borrowing will result in dollar for dollar crowding out of private investment. If, instead, financing public projects results in no crowding out of private investment, then no adjustments using the shadow price of capital are necessary. Benefits and costs should be discounted using the consumption rate of interest alone. However, the literature to date does not adequately support the assumption of zero crowding out. It is more likely that there exists some degree of private capital 43 Chapter 6: Social Discounting 8 Many authors cite high opportunity costs of public investments. Among these are Birdsall and Steer ( 1993), Schelling ( 1995), and Lyon ( 1994). On the technical issue of rates of return vs. net present values, see Lind ( 1990) and Cowen and Parfit ( 1992).

9 Clearly, such an approach cannot be followed when a particular action is mandated.

10 See Lind ( 1990) for this revision of the consumption rate of interest shadow price of capital approach. displacement within the spectrum between zero and dollar for dollar displacement. The degree of crowding out will depend on the magnitude of the policy or program being analyzed. Unfortunately, while the shadow price of capital adjustment requires an assessment of the proportion of costs that displace investment, 11 the literature provides little empirical evidence as to the relationship between project size and capital displacement. 12 <IP_ADDRESS> Applying the Consumption Rate of Interest Approach to Environmental Policies The extension of the consumption rate of interest shadow price of capital approach to the case of an economy " open" to substantial capital flows is relatively recent. And, as is true for most of the discounting literature, virtually all of the discussion focuses on public project financing, rather than on environmental policies that largely mandate that private parties undertake certain actions or expenditures in pursuit of social objectives. Finally, while it is intuitive to argue that private investments are not displaced by either additional government borrowing or mandatory private investments for environmental protection, it is often the gross gains and losses of the affected parties in the economy that are the focus of economic impact analyses. How the change in the assumption concerning the availability of investment funds to the economy translates into these gross gains and losses is critical for conducting accurate environmental policy assessments.

For all of these reasons, it is worth clarifying the capital displacement and adjustment issue for environmental policies that mandate capital investments in the context of both the " open" and " closed" economy assumptions regarding capital flows.

Environmentally Mandated Private Investments in a " Closed" Economy To focus closely and exclusively on the shadow price of capital adjustment issue, some simplifying assumptions are helpful. Assume that there is no risk and uncertainty, that all firms and the government borrow at the interest rate i, that taxes on investment income are levied on all sources of such income at a rate of t, and that the resulting post tax interest rate, r (= i × ( 1 t)), is the rate at which individuals discount future consumption. 13 Further, assume that the net of tax returns from all investments are consumed in each year ( to assist in making this illustration as simple as possible). Assume, finally, that the supply of investment funds is perfectly inelastic with respect to their price, the interest rate.

Consider, first, a public project that costs $ 1, is financed through taxes on labor and other factors of production ( but not capital), and offers future environmental benefits. Assuming that increased current taxation only reduces consumption, the cost of the project is this amount of reduced current consumption. Future benefits, once valued in terms of future consumption, can be discounted to the present using a social rate of discount equal to the consumption rate of interest. For the remainder of this discussion, the benefits side of the calculations will be ignored to focus on the cost calculation considerations.

Now, consider exactly the same project, but assume that it is financed only through government borrowing, which crowds out an equal amount of private sector investment. To calculate the costs of this project financing, it is helpful to analyze the impacts on the different entities affected. First, the private sector investors who lend $ 1 to the government instead of to private firms are indifferent. They receive the interest rate i from either source and, therefore continue to receive a stream of returns net of tax equal to $ 1 × r.

Next, consider the government, which can be thought of as representing the interests of citizens in future years. The foregone private investments would have generated a stream of tax revenues of $ 1 × t × i each year, which is lost. But the increased public debt is taxable, so the government regains this $ 1 × t × i each year and the streams of gained and lost tax revenues offset each other. Nevertheless, the government must service this new debt 44 Chapter 6: Social Discounting 11 See footnote 5 for a description of this adjustment.

12 See Lind ( 1990) for a summary of the empirical literature in this area.

13 The relevant tax rate t is the effective marginal tax rate. It is difficult to determine this rate in the aggregate with any reasonable degree of accuracy. by raising future taxes each year by the amount $ 1 × i ( assuming, for simplicity, that the debt is a perpetuity).

As a result, the cost of financing this public project through government debt in a closed economy context is a stream of decreased consumption experienced in the future of $ 1 × i per year forever. The present value of this stream of foregone consumption computed using the consumption rate of interest, r, exceeds $ 1. This is the essence of the shadow price of capital adjustment rationale The value of i exceeds r in this example because of the tax wedge between the social ( pre tax) rate of return on investments and the ( post tax) consumption rate of interest. This is the equivalent of observing that a taxable investment yields a private return of r per year to the investor and a " return" of t × i to the government in the form of tax revenues.

Assume now that the relevant investment is a private sector capital project that must be undertaken in order to comply with an environmental policy. To estimate the social costs of this requirement under the closed economy assumption, two polar cases are useful to examine: no cost shifting to consumers or other factors of production and full cost shifting to consumers through higher product prices.

In the case of no cost shifting to consumers, the owners of the firms required to make these investments either must obtain debt or equity funds or reduce their other investment and lending activities, to comply. Wherever the required funds originate, two facts are clear. One is that other taxable investments of $ 1 will not be undertaken. The second is that, because the price of the products or services into which this environmental investment flows does not rise, the mandated investment will produce no " return" for their owners or for the government in the form of future tax revenues. The result is that the owners of the affected firms lose a stream of investment income, $ 1 × r, and the government loses a stream of tax revenues of $ 1 × t × i, because of the displaced private investment. But since r= i × ( 1 t), this adds up to a stream of costs of $ 1 × i per year. Once again, this is essentially the shadow price of capital adjustment.

Now assume that the cost of the mandated environmental investment is shifted to consumers through higher prices, which rise by enough to provide the full social pre tax return of i. In this case, the owners of the firms required to make these investments are indifferent. Similarly, the government is indifferent   it still receives a stream of tax revenues from the $ 1 investment. Here, however, it is consumers of the affected product or service who are not indifferent. In fact, the product price increases they face are precisely enough to provide the $ 1 × i pre tax social return on the mandated investment. Here again, this is essentially the shadow price of capital adjustment.

Environmentally Mandated Private Investments in an " Open" Economy The central difference between the closed and open economy contexts concerns the conditions of supply of investment funds. In the closed economy case, the amount of these funds is fixed, so the total available for all projects, private and public, is constant. Hence, the key to analyzing that case lies in tracing the implications of altering the composition of the investments undertaken with and without a new public project or a new environmental policy mandating private investments.

In the open economy context, however, what is fixed is not the supply of investment funds, but the price at which they may be obtained. In this case, all investments worth undertaking without a new public project or a new environmental policy requiring investments will still be worth undertaking with those new policies   so that there will be no impact on capital availability and the level of private sector investments. This suggests that measuring the costs of these policies in this open economy context may be slightly different than in the closed economy case.

Purely tax financed public projects are not discussed here because the results for that case do not depend on the assumption concerning the supply of capital. For debt financed public projects, however, the results under the closed and open economy assumptions are very different In this open economy case, the government's increased $ 1 of borrowing does not change the level of U. S. private sector investment. Hence, the government must service the debt at a cost of $ 1 × i per year, but also gains from that $ 1 × i × t of tax revenues from these new 45 Chapter 6: Social Discounting taxable interest payments. 14 The net cost is only $ 1 × i × ( 1 t), which is the stream of future reduced consumption citizens will experience as the net cost of the new public project. But because i × ( 1 t)= r, this stream of reduced consumption is equal to $ 1 × r. Discounted at the consumption rate of interest, r, the present value cost is $ 1. This is the rationale for not using the shadow price of capital adjustment.

To analyze the implications of the open economy assumption for mandated private investments, the no and fullcost pass through polar cases continue to be helpful. In the case of no cost pass through, the results are very simple The owners of the firms required to make the investments to comply with an environmental policy will obtain the necessary funds either from their own resources that would have been invested elsewhere, or from other sources, and undertake the required investments. Because the price of the services or products subject to the new policy do not rise to compensate for these costs, no return to these owners or to the government in the form of tax revenues will result. But, because the supply of investment funds to the economy is perfectly elastic, no other private sector investments will be foregone.

The result in this case is that the owners of the entities required to make these investments will lose a stream of private investment returns of $ 1 × r ( their net of tax return on production investments) if the mandatory investment causes them to reduce investment elsewhere. Alternatively, the owners of the affected firms may increase their demands for investment funds in the market and continue with their pre policy investment plans. Nevertheless, because i is constant, all investment projects that were profitable before the policy is imposed will still be profitable and these investments will be undertaken as if the policy did not exist. Hence, the government loses no tax revenue as a result and no shadow price of capital adjustment is appropriate here.

Finally, if the costs of the mandated private investments are fully passed through to consumers, the owners of the affected firms are now indifferent. The government and the consumers of the relevant services or products, however are not. First, the consumers of the affected sector's output face price increases equivalent to $ 1 × i, which is the amount necessary to fully recoup the full pre tax social return on the invested capital. But the government gains a stream of tax revenues associated with this mandated investment, amounting to $ 1 × i × t per year. Again, all other investments are still undertaken because of the assumption regarding the supply of investment funds.

As a result, the net cost to society is the price increase borne by consumers, equal to $ 1 × i per year, minus the increase government tax revenues   which represents future reduced taxation   of $ 1 × i × t per year, for a net cost of only $ 1 × i( 1 t)=$ 1 × r. Thus, the shadow price of capital adjustment is not necessary here. But, note that the cost increase for the firm and its consumers is measured by the pre tax amount per year, $ 1 × i, not the net social cost of $ 1 × r per year. The former is the relevant measure for modeling private sector " economic impacts" and for assessing the gross gains and losses of a policy, while the latter represents the social perspective.

<IP_ADDRESS> Summary of Advice from the Economics Literature The vast majority of the traditional social discounting literature has focused on exploring the implications for public project evaluation of a few, probably very important, departures from the idealized no other distortions simplified economy for which unambiguous social discounting recommendations can be made. Yet, in the development of that literature, many matters have been addressed and are considered by many contributors to this literature to be somewhat settled, some of which are discussed above, and others not ( largely because they are not directly social discounting issues). In particular, for intra generational social discounting:

There is reasonable agreement that the social rate of discount ought to reflect the private rates of consumption discount of the citizens affected.

If social and private returns from private investments are different, then adjustments should be introduced 46 Chapter 6: Social Discounting 14 The taxability of the interest payments on the increased amount of government debt in an open economy context is complex because of the international nature of capital markets. Generally speaking, taxes are owed on interest earnings from government obligations to the country that pays the interest, although there are exceptions to this rule. Hence, if U. S. citizens increase their lending to the U. S. government, the interest earnings would clearly be taxable. If foreign investors purchase the increased U. S. government debt, normally these interest payments are taxable as U. S. income. to reflect this when and if policies alter private investment flows.

Uncertainty and risk should largely be addressed through appropriate valuation of costs and benefits ( e. g., certain monetary equivalents) rather than through modifications of the discount rate.

Changes in the values of environmental goods and other such factors should likewise be reflected in direct cost and benefit measurements, not through adjustments to the social discount rate.

Irreversibility of consequences is an option value concept and requires separate treatment in benefit cost analyses, but it does not provide a reason to adjust the discount rate.

Opportunity costs of other public and private uses for funds should be considered in evaluating the desirability of undertaking a particular public investment or policy. That a project offers a positive present value of net benefits when discounted using the consumption rate of interest does not by itself imply that the policy should be undertaken.

These conclusions demonstrate the significant progress made in the theoretical social discounting literature, especially regarding the implications of divergences between social and private rates of returns on investments. However, exactly what numerical rate of interest to use for social discounting in practical policy evaluations remains somewhat unsettled.

Moreover, some recent literature questions some of the most basic premises underlying the conventional social discounting analysis. For example, recent studies of individuals financial and other decision making suggest that even a single person may appear to value and discount different actions, goods, and wealth components differently. This " mental accounts" or " self control" approach suggests that individuals may well evaluate some aspects of the future quite differently from other consequences. The discount rate an individual might apply to a given future benefit or cost, as a result, may not be observable from market prices, interest rates, or other phenomena. This may be especially the case if the future consequences in question are not tradable commodities. Some recent evidence from experimental economics also indicates that discount rates appear to be lower the larger the magnitude of the underlying effect being valued, higher for gains than for losses, and tend to decline as the length of time to the event increases. 15 Despite all of these limitations, practical economic analyses must use social discounting to assist in evaluating environmental policies. Hence, even limited guidance is helpful in developing recommendations for practical analyses. What is offered in the empirical literature for choosing a social discount rate focuses on estimating the consumption rate of interest at which individuals translate consumption through time with reasonable certainty.

For this, historical rates of return, post tax and after inflation on " safe" assets, such as U. S. Treasury securities, are normally used, typically resulting in rates in the range of one to three percent. 16 Some studies have expanded this portfolio to include other bonds, stocks, and even housing and this generally raises the range of rates slightly. It should be noted that these rates are ex post rates of return, not anticipated, and they are somewhat sensitive to the time periods selected and the classes of assets considered 17 A recent study of the social discount rate for the United Kingdom places the consumption rate of interest at two to four percent, with the balance of the evidence pointing toward the lower end of the range. 18 47 Chapter 6: Social Discounting 15 Shefrin and Thaler ( 1988) and Thaler ( 1985) are central sources for the mental accounts idea and Lowenstein and Thaler ( 1989) report numerous examples of various inconsistencies and other aspects of individual intertemporal choices.

16 Estimates of the consumption rate of interest ( an individual's marginal rate of time preference) could be based on either after tax lending or borrowing rates. Because individuals may be in different marginal tax brackets, have different levels of assets, and have different opportunities to borrow and invest, the type of interest rate that best reflects marginal time preference will differ among individuals. Additionally, individuals routinely are observed to have several different types of savings, each possibly yielding different returns, while simultaneously borrowing at different rates of interest. Thus, discerning an average marginal rate of time preference from observed interest rates is very difficult. However, the fact that, on net, individuals generally accumulate assets over their working lives suggests that the after tax returns on savings instruments generally available to the public will provide a reasonable estimate of the consumption rate of interest.

17 Ibbotson and Sinquefield ( 1984 and annual updates) provide historical rates of return for various assets and for different holding periods.

18 Lind ( 1982b) offers some empirical estimates of the consumption rate of interest. Pearce and Ulph ( 1994) provide the estimates of the consumption rate of interest for the United Kingdom. Lyon ( 1994) provides estimates of the shadow price of capital under a variety of assumptions. Finally, for the shadow price of capital, even less concrete empirical guidance is available. This parameter depends on the consumption rate of interest, the gross of tax rate of return on private investment, and the rate of consumption out of net investment returns, among other factors. Depending on the magnitudes of these factors, shadow prices from close to one to three, 20, 100, and infinity can result. Lyon ( 1990) has an excellent review of how to calculate the shadow price of capital and possible settings for the various parameters that determine its magnitude. Moreover, the shadow price of capital adjustment will require an assessment of the proportion of project costs that displace private investment. Whether or not this adjustment is necessary appears to depend largely on whether the economy in question is assumed to be open or closed and on the magnitude of the intervention or program considered relative to the flow of investment capital from abroad. 19 <IP_ADDRESS> Guidance for Intra Generational Social Discounting For economic analyses of intra generational policies analysts should apply the consumption rate of interest approach. There should be no adjustments using the shadow price of capital unless there are strong reasons to believe that a particular policy will affect the level of U. S. private sector investment. 20 Based on historical rates of return on relatively risk free investments, adjusted for taxes and inflation, a consumption rate of interest measured at two to three percent is justified.

OMB's own guidance on discounting21 currently recommends discounting using a rate of seven percent, an estimate of the average real pre tax rate of return generated by private sector investments. EPA economic analyses therefore should provide estimates of the present values of costs and benefits using both a two to three percent rate and OMB's guidance on discounting. In some cases, a sensitivity analysis at discount rates within this range may provide useful information to decision makers.

In addition, all analyses should present the undiscounted streams of benefits and costs. This is not equivalent to calculating a present value using a discount rate of zero. In other words, the flow of benefits and costs should be displayed rather than a summation of values.

6.3.2 Inter Generational Social Discounting This section focuses on social discounting in the context of policies with very long time horizons involving multiple generations. Policies with potential inter generational impacts include global climate change, radioactive waste disposal, groundwater pollution, and biodiversity. Because of potentially large or catastrophic impacts on unborn generations and because policies with very long time horizons often involve high costs imposed by current generations, there is less agreement in the literature on the appropriate approach to discounting over very long time horizons. This section attempts to present a balanced discussion of alternative points of view. The discussion first focuses on how the point of departure for inter generational discounting differs in some very fundamental ways from that of intra generational social discounting. Next, various approaches for deciding whether and how to discount when evaluating inter generational policies are reviewed. Finally, the section concludes by summarizing the advice offered by the economics literature and EPA's new guidelines for inter generational social discounting.

48 Chapter 6: Social Discounting 19 Studies suggesting that increased U. S. government borrowing does not crowd out U. S. private investment generally examine the impact of changes in the level of government borrowing on interest rates. The lack of a significant positive correlation of government borrowing and interest rates is the foundation of this conclusion. Because changes in yearly U. S. government borrowing during the past several decades have been in the many billions of dollars, it is reasonable to conclude that EPA programs and policies costing a fraction of these amounts are not likely to result in significant crowding out of U. S. private investments.

20 As the estimation of the shadow price of capital can be a costly exercise, analysts should use a value of information approach to determine whether it is worthwhile to pursue a quantitative assessment of the effects of private capital displacement. Should a quantitative assessment be undertaken, the analysis should include a sensitivity analysis of alternative assumptions regarding the degree of crowding out.

21 OMB Circular A 94, " Guidelines and Discount Rates for Benefit Cost Analysis of Federal Programs," October 29, 1992 ( note: see updates to cost effectiveness rates   most recent released in January 2000, http:// www. whitehouse. gov/ OMB/ circulars/ a094/ a094. html ( accessed 8/ 28/ 2000)) and U. S. Office of Management and Budget, Guidelines to Standardize Measures of Costs and Benefits and the Format of Accounting Statements, report M 00 08, March 22, 2000,. http:// www. whitehouse. gov/ media/ pdf/ m00 08. pdf ( accessed 8/ 28/ 2000). <IP_ADDRESS> Analytical Foundation of Inter Generational Social Discounting One obvious problem with long time horizon policies is that many of the people affected are not alive. Hence, while the preferences of each affected individual are knowable ( if probably unknown in practice) for intra generational social discounting problems, they are essentially unknowable for those involving future generations not yet born. This is not always a severe problem for practical policymaking, especially when policies impose relatively modest costs and benefits, or when the benefits begin immediately, or in the not too distant future. And most of the time, it suffices to assume that future generations will have preferences much like those of present generations.

The more serious challenge posed by long time horizon situations arises primarily when costs and benefits of an action or inaction are very large and are distributed asymmetrically over vast expanses of time. Here, the crux of the problem is that future generations are not present to participate in making the relevant social choices. Instead, these decisions will be made only by existing generations. Social discounting in these cases can no longer be thought of as a process of consulting the preferences of all affected parties concerning their valuation today of effects they will experience in different time periods.

Moreover, compounding interest over very long time horizons can have profound impacts on the inter generational distribution of welfare. An extremely large cost far enough in the future has essentially zero present value when discounted at even a low rate. But a modest sum invested today at the same low interest rate also can grow to a staggering amount given enough time. Therefore, mechanically discounting very large distant future effects of a policy without thinking carefully about the ethical implications is not advised.

<IP_ADDRESS> Perspectives on Inter Generational Social Discounting The social discounting literature contains many different perspectives on social discounting in inter generational contexts. This section briefly describes the major approaches and their theoretical motivations. The focus in this discussion is on the social discount rate itself, so such other issues as the shadow price of capital adjustments, while clearly still relevant under certain assumptions, are kept in the background.

Social Welfare Planner Approach One popular recommendation is that social discounting for inter generational policies should be based upon methods economists have used for many years in optimal growth analyses. In these models, the policy maker is understood to be maximizing the utilities of all present and future generations using a well defined social welfare function. 22 In optimal growth models, the social rate of discount generally equals the sum of two factors. One is a discount rate for pure time preference, which measures the degree to which the social planner favors the utility of current and near future members of society over that of individuals in the more distant future. The other is an adjustment reflecting the fact that the marginal utility of consumption will decline over time as consumption per capita increases ( equal to the elasticity of marginal utility multiplied by the rate of increase of consumption over time).

If the world actually corresponded to the theoretical construct of an optimal growth model and there were no taxes or other distortions, the social discount rate as defined in these models would be equal to the market interest rate. And, the market rate of interest, in turn, would also be equal to the social rate of return on private investments and the consumption rate of interest. But because the world contains many distortions, and is not likely to conform to the conditions that characterize optimal growth models, the social rate of discount is not observable in the economy.

Recent practical applications of this approach to very longtime horizon analyses have therefore attempted to estimate the social discount rate by constructing it from its components. Most assume that the rate of pure time discount is zero, adhering to the ethical precept that the policy maker ought not to inherently favor present generations' consumption over that of future generations. For the other component of the social discount rate,

49 Chapter 6: Social Discounting 22 Key literature on this topic includes Arrow et al. ( 1996), Lind ( 1994), Schelling ( 1995), Solow ( 1992), Manne ( 1994), Toth ( 1994), Sen ( 1982), Dasgupta ( 1982), and Pearce and Ulph ( 1994). hypothetical, but perhaps plausible, estimates of the elasticity of marginal utility and the rate of growth of consumption over time are introduced. The product of these two factors is the implied social discount rate. This computational procedure in essence derives an implied social rate of discount under the assumption that future generations will be richer than current generations, so that the marginal utility of consumption is projected to fall over time. Rates developed using this technique generally range from one half percent to three percent. 23 Optimal growth modeling, however, is only one strand of the substantial body of research and writing on intertemporal social welfare maximization and optimal growth. This literature extends from the economics and ethics of inter personal and inter generational wealth distribution, to the more specific environment growth issues raised in the " sustainability" literature, and even to the appropriate form of the social welfare function, e. g., utilitarianism or Rawls' maxi min criterion.

Clearly, economics alone cannot provide definitive guidance for selecting the " correct" social welfare function or the social rate of time preference. Nevertheless, economics can offer a few insights concerning the implications and consequences of alternative choices and some advice on the appropriate and consistent use of the social welfare function approach as a policy evaluation tool.

Approaches Based on Existing Individuals' Preferences The major alternative to the social welfare planner approach for inter generational discounting is to rely on the preferences of current individuals for an appropriate discount rate. At its core, this perspective rejects the view that the problem is one of balancing the interests of all humans who will live now and in the future. Instead, according to this perspective, it is fundamentally about individuals alive today allocating their scarce resources to competing ends, one of which happens to be the welfare of future generations. Several specific approaches fall into this category. Consumption rate of interest/ infinitely lived individuals: Although not popular in theoretical terms, in practice it is common to adopt the approach of simply making no great distinction between intergenerational and intra generational social discounting Models of infinitely lived individuals, for example suggest the consumption rate of interest as the social discount rate. But the assumption that people live forever is contrary to the fact that individuals actually do not live long enough to experience distant future consequences of a policy and to report today the present values they place on those effects. As such, models of infinitely lived individuals essentially ignore the fundamental problem posed in evaluations of policies that affect distant future generations.

Inter generational discounting vs. time discounting Another suggestion for social discounting in inter generational contexts is to examine possible differences between how current individuals evaluate the welfare of their descendants versus how they discount their own future consumption. 24 It is possible that the year by year exponential time discounting 25 that underlies an individual's allocation of his or her own consumption in the present and the future does not apply to this individual's valuation of his or her descendant's welfare. That is, a person might indeed value future generations' consumption less than his or her own current and future consumption, but not as low as would be implied by standard discounting techniques. An individual's present valuation of the consumption of successive future generations might decline gradually and approach some constant positive value, so that the value of a unit of consumption by a person 10 generations from the present might be considered to be the same as a unit of consumption by a person 11 generations from now.

A related line of reasoning suggests that large scale catastrophic consequences in the future are viewed differently than marginal changes in welfare, so that it matters little whether these possibilities are 100 years 50 Chapter 6: Social Discounting 23 See IPCC ( 1996), pp. 131 132.

24 Sources discussing this approach include Rothenberg ( 1993), Cropper et al. ( 1992), Shefrin and Thaler ( 1988), Thaler ( 1985), and Cowen and Parfit ( 1992).

25 Exponential time discounting applies discounting factors to future values that increase as the time between the present and the future when those values will be experienced increases. As a result, the present value of a benefit to be enjoyed 50 years from now is much higher than the present value of the same benefit if it accrues 100 years from now. or 1,000 years in the future. If so, applying exponential or year by year, time discounting to such future consequences is inappropriate.

Revealed/ stated preferences for altruism: According to this view, environmental policies that affect distant future generations are considered to be altruistic acts. 26 As such, they should be valued by current generations exactly the same as other acts of altruism. Hence, the discount rate in question is not that applied to an individual's consumption, but instead that applicable for an individual's valuation of the consumption or welfare of someone else.

At least some altruism is apparent from international aid programs, private charitable giving, and bequests within overlapping generations of families. But the evidence suggests that the importance of other people's welfare to an individual appears to grow weaker with temporal, cultural, geographic, and other measures of " distance." The implied discount rates that survey respondents appear to apply in trading off present and future lives are also relevant under this approach. One such survey ( Cropper, et al., 1992) suggests that these rates are positive on average, consistent with the rates at which people discount monetary outcomes, and decline as the time horizon involved lengthens.

Opportunity cost of alternatives: A variety of perspectives in the inter generational discounting literature converge on the broad notion that devoting resources to long time horizon environmental projects   largely because low discount rates appear to make these attractive in present value terms   neglects numerous other social investment opportunities with higher values. 27 Advocates of this point of view point to numerous alternative social investments that would generate far larger benefits now and in the future, such as basic infrastructure, education, medical assistance, and other projects in developing nations.

Depending on the context, this point of view is often expressed in two different ways: ( 1) many other investments would be more beneficial to society and so long time horizon environmental programs face very high opportunity costs, and ( 2) the rates of return offered by these alternative investments are high and these rates ought to be used as the social rate of discount.

As noted earlier in the context of intra generational social discounting, the first statement of this opportunity cost argument is the correct one, the second is somewhat problematic. The opportunity costs of alternative government or private investment programs are appropriately measured by calculating their present values using the social rate of discount. If these projects have higher rates of return than the social discount rate, their social present values will also be high. But this does not imply that the social rate of discount itself ought to be set equal to some alternative project's rate of return. For example, an alternative project might offer a very large rate of return for only one year, but this should not become the social rate of discount for very long time horizon projects and policies.

Paretian compensation tests: One final approach for social discounting in an inter generational context returns to the theoretical motivation and ethical underpinnings of intra generational social discounting This approach views social discounting in intergenerational contexts as a question of whether the distribution of wealth among many different generations could be adjusted in order to compensate the losers under an environmental policy and still leave the gainers better off. Whether gainers could compensate losers hinges on the rate of interest at which society ( the U. S. presumably or perhaps the entire world) can transfer wealth across hundreds of years. Some argue that in the U. S. context, a good candidate for this rate is the federal government's borrowing rate.

What lies at the foundation of this approach is the goal of maintaining overall inter generational equity. The implicit assumption is that society starts from a position at which the distribution of wealth across present and future generations is " acceptable." Then 51 Chapter 6: Social Discounting 26 Schelling ( 1995) and Birdsall and Steer ( 1993) are good references for these arguments.

27 Many authors cite high opportunity costs of public investments. Among these are Birdsall and Steer ( 1993), Nordhaus ( 1993), Schelling ( 1995), and Lyon ( 1994). it is discovered that some current environmental action or inaction will impose large burdens on future generations. To maintain inter generational equity, some sort of accumulation fund is necessary to provide compensation for those harms.

While this approach offers solid advice for selecting a social discount rate for inter generational policy evaluation, its resolution of the many difficult social choice problems posed by such policies rests on two critical assumptions. One is that the initial distribution of inter generational wealth is socially acceptable. If this is not the case, it is not clear that attempting to maintain that distribution after discovering the long term environmental problem is an appropriate goal.

Second, if the compensation fund is not accumulated, then the decision not to remedy this environmental problem is once again recast as an inter generational equity problem, not a question purely of economic efficiency. There is considerable skepticism regarding the willingness of the current generation to provide these compensation funds and a significant concern that intervening generations might not continue the accumulation process. Thus, actually undertaking the process of locking away sufficient savings for distant future generations to compensate them for environmental harms is a very different matter than determining the rates of interest at which such a fund might grow.

<IP_ADDRESS> Summary of Advice from the Economics Literature There is little consensus in the economic literature on social discounting for inter generational policies. In particular, the fundamental choice of what moral perspective should guide inter generational social discounting   a social planner who weighs the utilities of present and future generations, the preferences of the current generations regarding future generations or perhaps other approaches   cannot be made on economic grounds alone. It is important, however, to view this result in the proper context. In fact, the practical effect of this lack of consensus concerning social discounting for inter generational policies is not as profound as it at first appears. The major problems with discounting in long time horizon contexts occur in probably a few cases out of a vastly larger set, particularly where costs and benefits are inherently high and are substantially divorced in time. But the environmental policies that fit this description are uncommon because most environmental programs are relatively short in duration and reversible, with their time frames determined largely by capital investments.

<IP_ADDRESS> Guidance for Inter Generational Social Discounting Based on the theoretical social discounting literature and other considerations, economic analyses of policies with inter generational effects should generally include a " no discounting" scenario by displaying the streams of costs and benefits over time. This is not equivalent to calculating a present value using a discount rate of zero ( i. e., the flow of benefits and costs should be displayed rather than a summation of values).

Economic analyses should present a sensitivity analysis of alternative discount rates, including discounting at two to three percent and seven percent as in the intra generational case, as well as scenarios using rates in the interval one half to three percent as prescribed by optimal growth models. The discussion of the sensitivity analysis should include appropriate caveats regarding the state of the literature with respect to discounting for very long time horizons.

6.4 Discounting and Non Monetized Effects Despite analysts' best efforts to assign monetary values to all of the consequences of an environmental policy, there are instances in which monetization is not feasible. This section briefly explores social discounting when some elements are not expressed in monetary terms. 28 52 Chapter 6: Social Discounting 28 Although this discussion focuses exclusively on non monetized benefits, many cost categories are often not monetized as well. The time costs consumers experience as a result of some policies, the financial costs of business delays that result from others, and the quality and performance impairments caused by yet other policies often are not monetized in economic analyses. Discounting policy regarding these non monetized effects should largely track discounting practices for monetized costs unless there are reasons for not doing so, similar to those described in this section for leaving some non monetized benefits undiscounted. 6.4.1 Perspectives on Discounting Non Monetized Effects One strategy for addressing future non monetized effects is to discount them as though they had been monetized. Some argue, however, that environmental benefits that have not been monetized cannot   or should not   be discounted and summarized together with costs in a costeffectiveness or benefit cost summary. Two basic lines of reasoning are normally offered. One is that because discounting is essentially a financial process designed to evaluate investment decisions, it is only relevant to dollardenominated streams, and so benefits that are in physical rather than dollar terms cannot be discounted. Discounting some types of benefits, such as avoided damages to human lives or natural resources, treats these tangible risk related benefits as monetary outcomes, when they are not in fact financial consequences.

The other line of reasoning for not discounting non monetized benefits is that it is ethically unacceptable to discount physical units. If, for example, cancer cases that occur in the future are discounted to the present, this effectively asserts that a future cancer case is not really a cancer case, but rather is only 80 percent, 20 percent, or some other fraction of a " full" current cancer case. Discounting therefore somehow cheapens the future effect's value or reduces its importance and is unfair to future individuals or generations whose lives or natural resources are at stake. This argument is often applied not only to human health and environmental effects that are simply enumerated but also to those that are monetized.

Evaluating these arguments requires a clear understanding of the various reasons why benefits might not be monetized in any given analysis. In some cases, benefits are not monetized because the environmental and health impacts may be unknown, so that only changes in emissions, production exposure, or other imperfect proxies for benefits, damages, or harms, are available. Sometimes there may be an estimated time stream of human health and environmental impacts, but the needed valuation tools and information on how to monetize the benefits are not   or are only partially   available. Finally, in still other cases, physical effects have been estimated and could be monetized but this last step   converting measured physical effects into dollar values of benefits   has simply not been taken.

6.4.2 When Discounting Non Monetized Effects Is Appropriate In many cases, quantitative information on the time streams of physical effects is available and these effects are measured in terms of human health consequences and ecosystem damages that correspond to endpoints that are normally monetized. If so, then these non monetized benefits ought to be discounted if monetized costs and benefits are discounted. Discounting non monetary effects in these cases is not inherently different from discounting these units after attaching a unit value in dollar terms. What is being conveyed is the notion that effects felt farther in the future are worth less in today's terms than those that occured earlier in time. Thus, if two policies have identical current costs and the same amount of benefits in the future except that one produces these benefits earlier in time, the policy that offers earlier benefits will have a higher social value.

Choosing not to discount non monetized benefits can have perverse consequences. First, to the extent that the act of discounting and the choice of discount rate embody a rational investment criterion, failing to discount non monetized benefits may produce results that appear to be irrational or intrinsically unappealing. Suppose, for example, there is a policy that is estimated to save five lives in the year it is implemented. This policy can either be implemented today ( Option A) or 20 years from now ( Option B), and the undiscounted costs in current dollars are the same for both options. If the discounted costs are compared with undiscounted benefits, a cost effectiveness evaluation will clearly favor Option B. Thus, failing to discount benefits can produce a situation in which society has little motive to pursue current environmental benefits because by investing instead, larger net environmental benefits can be gained in the more distant future.

Finally, surveys that examine individuals' attitudes toward public policies with non monetized benefits suggest that people do appear to apply a positive discount rate to these future effects. For example, contingent valuation studies ( Cropper et al., 1992; Carson et al., 1987; Horowitz and Carson, 1990) that look at individuals' preferences for 53 Chapter 6: Social Discounting saving lives find that individuals prefer projects that save lives in the near term over equivalent cost projects that save lives in the future.

6.4.3 When Discounting Non Monetized Effects Might Not Be Appropriate While there are many cases in which non monetized benefits can and should be discounted along with all of the other costs and benefits of environmental policies, there are others in which benefits are not monetized for reasons that pose more significant problems for discounting. Specifically, sometimes the available measures of benefits are very poor proxies for ultimate damages, making it difficult to discount them correctly.

When an analysis stops far short of the physical effects that are good proxies for damages, the relationship between harms and emissions   or other relevant physical measures   might be poorly understood. In the case of the greenhouse effect, for example, the ultimate impact of a ton of greenhouse gas emitted in a given year depends on the subsequent change in the time paths of temperature, sea level, and other variables, and on the physical effects and economic impacts accompanying these changes. Changes in temperature depend, in turn, on the magnitude of emissions of all greenhouse gases over time and their radiative forcing. Further, the impacts of climate change may depend not only on the absolute levels of these effects, but on the rate at which they occur. Because linking quantified physical harms to a unit of emissions is a difficult task, discounting greenhouse gas emissions would be a premature and problematic step in determining the cost effectiveness of two alternative emission reduction strategies.

Similarly, even when benefit estimates are based on linkages from emissions to other physical and biological endpoints often these benefit measures are still not close enough to the endpoints of ultimate concern to allow discounting For example, although pollution damages can be measured in terms of species diversity, ecosystem health, and forest productivity, the further detailed linkages from those damages to current and future recreation, production non use, or other values identified by economists and ecologists often do not exist. Discounting non monetized effects is also not warranted when doing so actually conceals information of value to policy makers. For example, suppose a policy reduces current and future effluent discharges to a river. Suppose further that this river has a complex chemistry, so that interactions between the effluent reduced by this environmental policy and other natural and human inputs to the river are unknown and/ or the relationship between effluent discharges and damages is nonlinear ( e. g., the river is subject to degradation only after passing some threshold). Here, the same quantities of effluent reduction in different time periods are not necessarily identical in their effects, so not only is there a time element to contend with, but also possible differences in ultimate environmental benefits In this case it might be far more useful to display the stream of effluent reduction and probabilities of exceeding thresholds each year, rather than to discount all of the future effluent reduction.

In all of these examples, the problem is that analysts have an incomplete understanding of the relationship between emissions   and production or other physical units that are potentially subject to control   and the actual harm to human health or the environment that result. However, a general preference for earlier benefits over later ones still applies. The problem is that discounting in these cases masks important information by implicitly assuming that a unit of benefits in one period has an identical effect on the ultimate benefit consequences of concern as a unit of the same benefit in another period. When non monetized benefits measures are far from the human health and other benefit categories of true concern, this assumption often is contrary to reality.

When it is not appropriate to discount certain non monetized benefits, comparisons of costs and benefits can still be made without directly discounting the benefits. For example, if costs and benefits occur in each time period over the course of a policy, and these do not change significantly over time, net social benefits can be explored without discounting by examining a representative year's costs and benefits. Similarly, if the benefits are relatively constant through time, but the costs are not, the costs can be annualized and compared to the annual benefits using cost effectiveness analysis. Another approach is to cumulate costs forward with interest to compare this future value to the benefits, a method that is particularly suitable when the benefits occur in only one future year. If none of 54 Chapter 6: Social Discounting these methods applies, simply presenting the streams of costs and monetized and non monetized benefits to policy makers is often sufficient.

55 Chapter 6: Social Discounting 6.5 References Arrow, K. J., W. R. Cline, K. G. Maler, M. Munasinghe, R. Squitieri, and J. E. Stiglitz. 1996. Intertemporal Equity, Discounting, and Economic Efficiency. In Climate Change 1995: Economic and Social Dimensions of Climate Change, edited by J. P. Bruce, H. Lee, and E. F. Haites. Cambridge, MA: Cambridge University Press.

Birdsall, N. and A. Steer. 1993. Act Now on Global Warming But Don't Cook the Books. Finance & Development 30( 1): 6 8.

Carson, R. T., J. K. Horowitz, and M. J. Machina. 1987. Discounting Mortality Risks. Discussion Paper 87 25, UCSD Department of Economics, University of California, San Diego, September 1987.

Cowen, T. and D. Parfit. 1992. Against the Social Discount Rate. In Philosophy, Politics, and Society: Series 6, Future Generations, edited by P. Laslett and J. Fishkin. New Haven, CT: Yale University Press.

Cropper, M. L., S. K. Aydede, and P. R. Portney. 1992. Public Preferences for Life Saving. Discussion Paper CRM 9201, Resources for the Future, Washington, D. C.

Dasgupta, P. 1982. Resource Depletion, Research and Development, and the Social Rate of Return. Chapter 8 in Discounting for Time and Risk in Energy Policy, edited by R. C. Lind. Washington, D. C.: Resources for the Future.

Horowitz, J. K., and R. T. Carson. 1990. Discounting Statistical Lives. Journal of Risk and Uncertainty 3( 4): 403 413.

Ibbotson, R. G., and R. A. Sinquefield. 1984. Stocks, Bonds, Bills, and Inflation: The Past and the Future, Financial Analysts Research Foundation, 1982. Updates published as Stocks, Bonds, Bills and Inflation Yearbook, Annual, Chicago, IL: R. G. Ibbotson Associates, Inc.

IPCC. 1996. Intertemporal Equity, Discounting, and Economic Efficiency. Chapter 4 of Climate Change 1995: Economic and Social Dimensions of Climate Change. Contributions of Working Group III to the Second Assessment Report of the Intergovernmental Panel on Climate Change. Melbourne, Australia: Cambridge University Press.

Kolb, J. A., and J. D. Scheraga. 1988. A Suggested Approach for Discounting the Benefits and Costs of Environmental Regulations. Memorandum prepared by U. S. EPA. Office of Policy, Planning and Evaluation, Washington, D. C.

Kolb, J. A., and J. D. Scheraga. 1990. Discounting the Benefits and Costs of Environmental Regulations. Journal of Policy Analysis and Management 9: 381 390.

Lind, R. C. ( ed.) 1982a. Discounting for Time and Risk in Energy Policy. Washington, D. C.: Resources for the Future.

Lind, R. C. 1982b. A Primer on the Major Issues Relating to the Discount Rate for Evaluating National Energy Options. Chapter 2 of Discounting for Time and Risk in Energy Policy, edited by R. C. Lind. Washington, D. C.: Resources for the Future.

Lind, R. C. 1990. Reassessing the Government's Discount Rate Policy in Light of New Theory and Data in a World Economy with a High Degree of Capital Mobility. Journal of Environmental Economics and Management 18( 2): 8 28.

Lind, R. C. 1994. Intergenerational Equity, Discounting, and the Role of Cost Benefit Analysis in Evaluating Global Climate Policy. In Integrative Assessment of Mitigation, Impacts, and Adaptation to Climate, edited by N. Nakicenovic, W. D. Nordhaus, R. Richels, and F. L. Toth. Laxenburg, Austria: International Institute of Applied Systems Analysis ( IIASA).

Lowenstein and Thaler. 1989. Intertemporal Choice. Journal of Economic Perspectives, 3( 4): 181 193.

Lyon, R. M. 1990. Federal Discount Rate Policy, the Shadow Price of Capital, and Challenges for Reforms. Journal of Environmental Economics and Management 18( 2): 29 50.

56 Chapter 6: Social Discounting Lyon, R. M. 1994. Intergenerational Equity and Discount Rates for Climate Change Analysis. Paper presented at IPCC Working Group III Workshop on Equity and Social Considerations Related to Climate Change, 18 22 July, Nairobi, Kenya.

Manne, A. S. 1994. The Rate of Time Preference: Implications for the Greenhouse Debate. In Integrative Assessment of Mitigation, Impacts, and Adaptation to Climate Change, edited by N. Nakicenovic, W. D. Nordhaus, R. Richels, and F. L. Toth. Laxenburg, Austria: International Institute for Applied Systems Analysis ( IIASA).

Nordhaus, W. D. 1993. Reflections on the Economics of Climate Change. Journal of Economic Perspectives 7( 4): 11 25.

Pearce, D. W. and R. K. Turner. 1990. Discounting the Future. Chapter 14 in Economics of Natural Resources and the Environment. Baltimore, MD: The Johns Hopkins University Press.

Pearce, D. W. and D. Ulph. 1994. A Social Discount Rate for the United Kingdom. Mimeo No. 95 01, Centre for Social and Economic Research on the Global Environment, University College London and University of East Anglia, UK.

Rothenberg, J. 1993. Economic Perspectives on Time Comparisons: Evaluation of Time Discounting. In Global Accord: Environmental Challenges and International Responses, edited by C. Nazli. Cambridge, MA: MIT Press.

Schelling, T. C. 1995. Intergenerational Discounting. Energy Policy 23( 4/ 5): 395 401.

Scheraga, J. D. 1990. Perspectives on Government Discounting Policies. Journal of Environmental Economics and Management 18( 2): 65 71.

Sen, A. K. 1982. Approaches to the Choice of Discount Rates for Social Benefit cost Analysis. Chap. 9 in Discounting for Time and Risk in Energy Policy, edited by R. C. Lind. Washington, D. C.: Resources for the Future.

Shefrin, H. M. and R. H. Thaler. 1988. The Behavioral Life cycle Hypothesis. Economic Inquiry XXVI( October): 609 43.

Solow, R. 1992. An Almost Practical Step Toward Sustainability. Paper presented at the Fortieth Anniversary of Resources for the Future, 8 October, in Washington, D. C.

Thaler, R. 1985. Mental Accounting and Consumer Choice. Marketing Science 4( 3): 199 214.

Toth, F. L. 1994. Discounting in Integrated Assessments of Climate Change. In Integrative Assessment of Mitigation, Impacts, and Adaptation to Climate, edited by N. Nakicenovic, W. D. Nordhaus, R. Richels, and F. L. Toth. Laxenburg, Austria: International Institute of Applied Systems Analysis ( IIASA).

U. S. Environmental Protection Agency. 1995. Regulatory Impact Analysis of Proposed Effluent Limitations Guidelines and Standards for the Metal Products and Machinery Industry. EPA/ 821/ R 95 023, Office of Water.

U. S. Office of Management and Budget. 1992. Guidelines and Discount Rates for Benefit Cost Analysis of Federal Programs. OMB Circular A 94, October 29, 1992. http:// www. whitehouse. gov/ OMB/ circulars/ a094/ a094. html ( accessed 8/ 28/ 2000).

U. S. Office of Management and Budget. 2000. Guidelines to Standardize Measures of Costs and Benefits and the Format of Accounting Statements, M 00 08, March 22, 2000. http:// www. whitehouse. gov/ media/ pdf/ m00 08. pdf ( accessed 8/ 28/ 2000).

57 Chapter 6: Social Discounting 58 Chapter 6: Social Discounting 7.1 Introduction to Analyzing Benefits At its roots, benefits analysis develops monetary values to inform the policy making process. These values are important because they allow decision makers to directly compare costs and benefits using the same measure ( i. e., dollars). A complete benefits analysis is also useful because it makes explicit the assumptions about the value of benefits embedded in different policy choices. This chapter focuses on those benefits that can be expressed in terms of dollars Chapter 10 discusses the presentation of nonmonetized benefits, those that cannot be expressed in dollar terms.

This chapter presents information on the theory and practice of benefits assessment for environmental policies. The discussion focuses on the benefits possible from a " typical" EPA policy or regulation that reduces emissions of contaminants into the environment However, the principles discussed here apply to other types of EPA policies, such as those that provide information or regulatory relief.

Most EPA benefits analyses face two serious challenges First, a given policy may produce many different benefits, but it is seldom possible to obtain a single, comprehensive value estimate for the collection of effects. This will often leave analysts with no alternative but to address these effects individually, aggregating values to generate an estimate of the total benefits of a policy alternative. Although there are exceptions to this " effect by effect" process for benefits analysis, much of the discussion in this chapter assumes that analysts will be forced to adopt this approach. The second major challenge faced by analysts is the difficulty of conducting original valuation research in support of specific policy actions. Because it is often too expensive or time consuming to perform original research, analysts will need to draw upon existing valuation estimates for use in benefits analysis. The process of applying these estimates to value the consequences of policy actions is called benefits transfer. Although the benefit transfer method is detailed in only one section, this chapter is generally written with benefit transfer in mind. For example, the descriptions of valuation methods in Section 7.5 include recommendations for assessing the quality of published studies. This is done to help analysts determine which studies deserve consideration for use in benefit transfers.

While analysts should always seek precision, they must make assumptions and exercise professional judgment to face the challenges noted above, as well as numerous others that arise in a benefits analysis. Existing value estimates, for example, are often subject to large uncertainty bounds due to measurement error, model uncertainty, and the inherent variability of individual preferences. When drawing from these studies   and when using quantitative estimates of any kind   analysts should carefully assess the quality of the data and should clearly state the reasons for their analytical choices. As with any analytical exercise the maxim " garbage in, garbage out" always applies.

The next section briefly summarizes the conceptual economic framework for benefits analysis. Section 7.3 outlines the effect by effect process for benefits analysis, including some general implementation principles. The fourth section defines and describes the types of benefits associated with environmental policies, followed by a review of available economic valuation methods in Section 7.5. This chapter 59 Chapter 7 Chapter 7: Analyzing Benefits concludes with specific recommendations for valuing types of benefits that are common to many EPA policies.

7.2 A Conceptual Framework for Benefits Analysis This section describes the theoretical economic foundation for valuing benefits. The theoretical discussion here serves as a conceptual starting point for benefits estimation   it is not a full and comprehensive treatment of welfare economics. The section includes a discussion of willingness to pay, consumer surplus, and analytical problems arising from the lack of markets for environmental improvements. References are provided for further reading on the specific topics introduced in this section, but useful texts for general reference include Just et al. ( 1982), Braden and Kolstad ( 1991), and Freeman ( 1993). Boardman et al. ( 1996), Brent ( 1995) and Hanley and Spash ( 1993) are useful, general references for benefitcost analysis.

7.2.1 Welfare Measures: Willingness to Pay and Willingness to Accept Compensation Economists define benefits by focusing on measures of individual satisfaction or well being, referred to as measures of welfare or utility. Economic theory assumes that individuals can maintain the same level of utility while trading off different " bundles" of goods, services, and money. For example, one may be equally satisfied by going fishing or viewing a movie. The tradeoffs individuals make reveal information about the value they place on these goods and services.

The willingness to trade off compensation for goods or services can be measured either as willingness to pay ( WTP) or as willingness to accept compensation ( WTA). Economists generally express WTP and WTA in monetary terms. In the case of an environmental policy, willingness to pay is the maximum amount of money an individual would voluntarily exchange to obtain an improvement ( or avoid a decrement) in the environmental effects of concern Conversely, willingness to accept compensation is the least amount of money an individual would accept to forego the improvement ( or endure the decrement). 1 WTP and WTA are not necessarily equal. The amount an individual would be willing to pay to obtain an environmental improvement is not necessarily identical to the amount he or she would be willing to accept to forego the improvement. One reason for this difference is that the starting points of the two measures differ. For environmental improvements, WTP uses the level of utility without the improvement as a reference point. WTA, on the other hand, uses as its reference point the level of utility with the improvement. Although these two measures are distinct and sometimes differ in practice, under conventional assumptions economists expect that the difference between them will be small in most cases. This result generally holds as long as the amounts in question are a relatively small proportion of the individual's income. Nonetheless, in the case of environmental goods, some additional considerations modify this general result. Hanemann ( 1991) shows that while this result holds for price changes, it does not strictly hold for changes in quantity or quality. Also, if a good has no close substitutes, differences in WTP and WTA may be large even if the effect on income is small.

WTP and WTA can also be identified with what they imply about property rights   whether entities have a right to pollute, so the public must pay them not to, or whether the public has a right to a clean environment and must be compensated for pollution For example, in the case of a policy that would reduce existing pollution levels, the use of WTP measures to value benefits implicitly assumes that the property right rests with the polluting firm.