Key Messages 
  • The choice of discount rate has been heavily debated in adaptation. Recent discussions support the use of lower discount rates to justify acting on climate change now, rather than delaying action. There is also growing consensus on the use of social discount rates which decrease in the long term.
  • The application of the Equivalency Principle provides a new way of guaranteeing a sustainable reallocation of the land in the long run perspective, taking into account the many dimensions of sustainable development which includes economics, society, institutions and environment.
  • The Equivalency Principle is based on the premise that the long term value of a piece of undeveloped land ought to be at least the same as the value of an identical piece of land in the vicinity to which permission has been granted for development.
  • This could be the case of making appropriate choices between ecosystem-based adaptation and grey infrastructures, which are affecting in different ways natural and developed land uses.

Context

Discounting is especially relevant in the context of climate change as it requires addressing long term and intertemporal decision-making. From an economic perspective, intertemporal choices have been assessed during the last 80 years using the discounted utility model, formulated by Samuelson (1937). The discounted utility model is based on the assumption that people make decisions by assessing its (positive or negative) consequences in a similar way to how the market evaluates gains and losses.

Decision-makers will have to determine which mitigation or adaptation policies should be implemented in the short term and which should be delayed based, among other criteria, on their relative costs and benefits. In this context, discounting has become a key element of economic analyses (Agrawala and Fankhauser, 2008). Lower discount rates imply a higher valuation today of a future outcome and, conversely, higher discount rates entail a lower present value for the future. In other words, low discount rates involve greater economic sacrifices to the current generation against future ones, which are expected to be “richer” according to the general economic theory. On the other hand, high discount rates may lead to an underestimation of future impacts.

The established framework currently supports the use of discount rates close to market interest rates. This ignores the “social welfare” component of discounting (Groom, 2014) and this is why many economists agree that the traditional framework (of using market rates as discount rates) is inadequate to address environmental problems characterised by irreversibility, uncertainty and long term horizons (Weitzman, 2009; Gowdy et al., 2010). In fact, scholars such as Stern (2007) or Weitzman (1998) have advocated for low (even negative) rates for discounting when discussing climate change policies,, whichwould justify acting now to combat climate change through an ambitious climate policy. However others, while agreeing on the need for change, do not consider the Stern Report to be an adecuate approach (Tol, 2006).

More recently, Groom (2014: 139) argues that “something resembling a consensus has emerged in the theory of discounting long-term horizons” which by agreeing in a rate that should decline with time, the so called “declining discount rates”, represents an intermediate position.

Policy and methodological developments 

The “Equivalency Principle” is an approach that allows to account for the dual nature of discounting: one being the “social welfare equivalent” to account for social welfare and second one, the “finance equivalent” that acknowledges current market conditions. The Equivalency Principle is based on “the premise that the long term value of a piece of undeveloped land ought to be at least the same as the value of an identical piece of land in the vicinity to which permission has been granted for development” (Chiabai et al., 2013).

In a context of land planning, the price of land depends greatly on whether it has been granted permission for development. In this way, two identical pieces of natural land located in the same area may have totally different prices if one of them has the permission to be built upon. This situation generates an anomaly with deep ethical and environmental implications, as it will always be cheaper to artificialise natural land than use or restore existing urban land. Chiabai et al. (2013) thus argued that both pieces of land should be valued similarly, as the long term value of both pieces of land is at least equivalent; accordingly future generations would probably give them equal utility and economic value.

The so-called Equivalency Principle (EP) can be applied when two conditions are met:

  1. Past decision making by the administrative unit of reference on development versus protection of natural assets has been socially optimal, so that the marginal present value of the preserved land is equal to the marginal present value of the adjacent developed land.
  2. Future generations may be affected in the long run by the decision taken on the land under analysis.

The application of the EP warrants the need for the collection of two types of datasets; the first to represent the values of natural, or undeveloped land, and the second to illustrate the values of adjacent lands that are either developed or have been allocated, or ‘zoned’, for a specific type of development purpose i.e. commercial, industrial, residential, by an administrative unit. Each database is then systemised and analysed, and the economic data compared and contrasted through the application of the Equivalency Principle.

To apply the EP, a discount rate is employed to ensure that the present value of both plots of land is made equivalent regardless of their classification. Practically, this is carried out through the conventional equation for net present value, which is solved for the discount rate.

The following steps should be carried out:

  • To derive estimates of the current Total Economic Value (TEV) of natural or undeveloped land types;
  • To collect data on prices of developed land, or undeveloped land for which permission has been granted for development (i.e. commercial, residential, industrial development). The data should be representative of lands adjacent to (i.e. in the region of) those natural sites where estimates of total economic values have been gathered.
  • Apply the Equivalency Principle, which is represented by the equation below:

Where PVN is the discounted flow value of the natural land in time; VN is the TEV of the natural land in time; d is the discount rate to be applied on the natural land; and g stands for the growth rate or appreciation of benefits of the undeveloped land over time.

As an example, the discount rates calculated for the UK (which has the largest database of land values) are presented in the table below. The discount rate is estimated for two socio economic scenarios: 1) no economic growth, meaning constant benefits, and 2) a growth rate following the “middle of the road” socio-economic scenario developed by the OECD (SSP2).

Discount rate (%) No growth Economic growth
Residential 0 – 1.71 1.23 – 2.94
Industrial 0 – 3.93 1.24 – 5.16

 

These results show very low discount rates, particularly for residential land, which supports policies that sustain the protection of natural land and ecosystems. The application of the EP represents therefore a key instrument to re-establish the “equivalency” between the economic importance of the two types of land (natural and developed). In practical terms, this means that in a context of climate change, when choosing between adaptation measures, the discount rate resulting from the application of the equivalency principle can favour the protection of natural land which has suffered from more intensive urbanisation processes, because its value has not been sufficiently recognised in past decision-making over the territory. Additionally, this rule reinforces the concept that discount rates should differ geographically, this way taking into account the local specificities including the preferences of society on development and environmental policies.

Main implications and recommendations 

The application of the principle provides a new way of guaranteeing a sustainable allocation of the land in the long run perspective, taking into account the many dimensions of a sustainable development which includes economics, society, institutions and environment.

This could be the case of making appropriate choices between ecosystem-based adaptation and grey infrastructures, which are affecting in different ways natural and developed land uses. One can imagine many other situations in which the application of EP can make a difference towards stricter protection of the natural assets, such as analysis of flood prevention measures in which hard infrastructures are opposed to softer nature-based solutions, or applications for health related adaptation measures.

A much more ambitious development of this approach would involve developing a Global Climate Discount rate (GCD) to be applied for most markets. This could be based on the fact that, we should be calculating the discount rate that will allow us achieving the 2 degree C average temperature increase target agreed in UNFCCC framework. Future research will allow us to estimate this rate and explore other applications of the EP.

Bibliography 

Agrawala, S., Fankhauser, S. (2008), Economic Aspects of Adaptation to Climate Change: Costs, Benefits and Policy Instruments. OECD Publishing, Paris.

Chiabai, A., Galarraga, I., Markandya, A., Pascual, U. (2013). The Equivalency Principle for Discounting the Value of Natural Assets: An Application to an Investment Project in the Basque Coast. Environmental and Resource Economics 56, 535–550, http://dx.doi.org/10.1007/s10640-012-9589-8

Gowdy, J.M. (2004), The revolution in welfare economics and its implications for environmental valuation and policy. Land economics 80, 239–257.

Groom, B. (2014), Discounting, in: Markandya, A., Galarraga, I., Sainz de Murieta, E. (Eds.), Routledge Handbook of the Economics of Climate Change Adaptation, Routledge International Handbooks. Routledge, Oxon (UK) and New York (USA), pp. 138–168.

Samuelson, P.A. (1937), A note on measurement of utility. Rev. Econ. Stud. 4, 155–161.

Stern, N. (2007), The economics of climate change: the Stern review. Cambridge University Press, Cambridge.

Tol, R.S. (2006), The Stern Review of the economics of climate change: a comment. Energy & Environment 17, 977–981.

Weitzman, M.L. (1998), Why the far-distant future should be discounted at its lowest possible rate. Journal of environmental economics and management 36, 201–208.