out - concepts An eye on the future Lawrence H. Goulder and...

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H. ARMSTRONG ROBERTS/CORBIS Lawrence H. Goulder and Robert N. Stavins D ecisions made today usually have impacts both now and in the future. But in carrying out policy evaluations to help decision-makers, economic analysts typically discount future impacts. In the environmental realm, many of the future impacts are benefits from policy-induced improvements. Thus, in the environmental- policy context, future benefits (as well as costs) are often discounted. This is controversial, partly because dis- counting can seem to give insufficient weight to future benefits and thus to the well-being of future generations. But does it actually shortchange the future? As economists, we have often encountered scepticism about dis- counting, particularly from non-economists. Some of this scepticism seems valid, yet some reflects misconceptions about the nature and purpose of discounting. By examining here how discounting affects the evaluation of environmental policies, we hope to clarify this concept. It helps to begin by considering the use of discounting in private investments. Here, the rationale stems from the fact that capital is productive — money earns interest. Con- sider a company deciding whether to invest $1 million in the purchase of a copper mine, and suppose that the most profitable strategy involves extracting the available copper three years from now, yielding revenues (net of extraction costs) of $1,150,000. Would investing in this mine make sense? Assume that the company has the alternative of putting the $1 million in the bank at 5% annual interest. Then, on a purely financial basis, the company would do better with the bank, as after three years it will have $1,157,625 ($1,000,000 2 (1.05) 3 ), com- pared with only $1,150,000 if it invests in the mine. Future returns We compared these alternatives by com- pounding to the future the up-front cost of the project. It is mathematically equivalent to compare the options by discounting to the present the future revenues or benefits from the mine. Discounting offers a quick way to check whether the return on a pro- ject is greater or less than the interest rate by taking future revenues and translating them into present units, using the ‘alternative rate of return’ (the bank’s rate of interest in our example) as the discount rate. So the dis- counted revenue in this case is $1,150,000 divided by (1.05) 3 , or $993,413 — less than the cost of the investment. Thus, the project would not earn as much as the alternative of putting money in the bank. If the discounted revenue exceeded the cost of the project, then the project would yield a higher return than the bank, and the company would be better off investing in the mine. This simple example suggests a general
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This note was uploaded on 05/30/2008 for the course AEM 2500 taught by Professor Poe,g. during the Spring '07 term at Cornell University (Engineering School).

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out - concepts An eye on the future Lawrence H. Goulder and...

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