Ecological Economics Lecture 10

1. Doctoral Program and Advanced Degree in Sustainable Energy SystemsDoctoral Program in Mechanical EngineeringDoctoral Program in Environmental Engineering Ecological EconomicsLecture 10 Tiago DomingosAssistant ProfessorEnvironment and Energy SectionDepartment of Mechanical Engineering

2. Classes and Deadlines CLASSES • Input-output analysis 9th June, 18:00-20:00 • Economic valuation 9th June, 20:00-22:00 • Multi-criteria assessment 7th July, 19:00-21:00 ASSIGNMENTS • Climate change + discounting 5th July • Input-output assignment 5th July • Green accounting assignment 5th July • Multi-criteria assessment 7th July (during class)

3. Present Value of Money Present Value Conversion of money flows to their present value NPV: Net Present Value i: interest rate VFt(t): value at instant t If VF is in current prices then i is the nominal interest rate If VF is in constant prices then i is the real interest rate

4. Nominal vs. real interest ratesThe Fisher relation For low rates, this is approximately equal to

5. Present Value of Utility Welfare Discrete time Continuous time

6. Discount RateJustification and Components The same monetary flow at different instants does not have the same value (time preference) CONSUMPTION: Uncertainty Being alive in the future (individual vs. society) Preferences in the future Value of the benefit or the cost CONSUMPTION: Impatience PRODUCTION: Capital productivity (opportunity cost of capital) Under certain conditions, the discount rate is equal to the real market interest rate consumption discount rate per capita consumption growth rate pure time preference rate utility discount rate elasticity of the marginal utility of consumption variation in survival probability Turner et al. (1994), pp. 102-106.

7. Discount RateCalculation Methods Pure rate of time preference “ A universal point of view must be impartial about time, and impartiality about time means that no time can count differently from any other. In overall good, judged from a universal point of view, good at one time cannot differ from good at another. Hence...the [pure time] discount rate...must be nought” Broom (1992, p. 92) cit. in Pearce e Ulph (1998, p. 273) Variation in survival probability Increase in mortality risk with age or Average population mortality rate Elasticity of the marginal utility of consumption Individual saving behaviour Social judgement on income transfers between people Per capita consumption growth rate Long run average of growth rate in real per capita consumption

8. Discount RateElasticity of the Marginal Utility of Consumption Elasticity of the marginal utility of consumption Utility of consumption Marginal utility of consumption Variation in marginal utility of consumption U(C)>0 U’(C)>0 U’’(C)<0 U(C) U(C) C C

9. Discount RateEthical Interpretation of the Elasticity of Marginal Utility Consider two families, with consumption resp. equal to C1and C2, with C1=2C2. The ratio of the marginal utilities of consumption is: • For different values of μ, this ratio is equal to:

10. Discount RateEstimate for the United Kingdom Pearce, D., D. Ulph (1998). A social discount rate for the United Kingdom. In D. Pearce, Economics and Environment, Edward Elgar, Cheltenham, UK, pp. 268-285.

11. Discount RateCriticisms The future is given a very low value Limits to growth It may not make sense to assume that economic growth will continue indefinitely (i.e., at a constant rate, i.e., exponentially) Negative discount rates Countries with economic de-growth The future has more value than the present