The EPA has reduced its estimate of the social cost of carbon from $51 per ton to $1 per ton, in part because it’s changing its discount rate from 3 percent to 7 percent. Off the cuff, that seemed nutty to me so I went digging. I eventually landed on the OMB circulars that provide guidance for regulatory agencies and they do indeed suggest that 7 percent discount rate should generally be used. The logic, as far as I can ascertain, is that 7 percent is the rate of return available in U.S. equity markets.
This is somewhat fortunate for me because it gives me an excuse to post one of my favorite charts
This is the inflation adjusted value of the Nikkei 225, the standard index of Japan’s equity markets, from 1960 to 2017. There are so many lessons in this chart, but I want to take out just one. An analyst looking at this chart in 1990 would have seen values that were nearly 8 times those in 1960. Cocktail napkin math tells me that’s three doubles over 30 years, which implies a double every 10 years, which in turn implies a roughly 7 percent return rate – eerily similar to what OMB gets looking at the U.S.
If what happens on that chart from 1990 to 2017 gives you pause, it should. The real return rate has been persistently negative. And that makes sense. It’s more or less implausible for asset values to grow consistently faster (or slower) than the underlying economy. Now, in the short run, deviations from this pattern can occur. For example, a rapidly aging population should expect to see asset values skyrocket as the population attempts to save for retirement at once. However, values are skyrocketing precisely because the opportunities for future growth are limited. For a given total market value in the future, higher prices today imply slower growth.
All of which is to say that it is highly unrealistic to expect a 7 percent private return of equity over the timescales for which climate change is relevant. Even 3 percent is probably pushing it.