How should the Government compare future benefits to present ones? Are they of equal value? Not according to the Treasury. If we accept the idea that future benefits are not equal to present ones, then how much should they be discounted by?
A strange question perhaps, yet one which the new chancellor has announced an answer to… 3 percent per year!
It is worth noting that John Healey is reflecting Treasury practice since 1967. This number found in the Treasury Green Book – called the “discount rate” – has varied significantly over time, ranging from as high as 10 percent to the current rate of 3.5 percent.
This raises the question: why does the Government care about how society values present consumption compared to the future, and what are the impacts of the discount rate?
The short answer is that an answer is deemed to be necessary to evaluate the true benefits of a policy decision or investment when those benefits are dispersed throughout time. This allows a policymaker to compare decisions across multiple time horizons.
In the background of this thinking is a premise that the future is big, both in terms of there being many years for it to happen in, and in terms of the number of people who will be there to experience benefits or harms in it.
A fear is that if we do not discount future benefits, then the future, due to its length and number of occupants, would swamp our public policy thinking.
In practice, those with this concern would question whether we could truly focus on a salient policy issue, say alleviating present poverty, or whether we would have to focus our resources on less urgent but future benefitting issues, such as building roads.
The spectre of the future would forever veto real present benefits in exchange for continuous marginal future gains.
To account for the spectre of the future, the Government discounts future benefits.
The exact way this is done this complicated; but in short, the Government measures future benefits, and then reduces them per year by the discount rate. This then allows for trade-offs to be analysed between policies which produce benefits and costs over different periods of time, without the weight of the future always overpowering the present.
Following the September announcement that the discount rate would change, Healey is set to provide details on when the discount rate will move to 3 percent at the Budget, set for 28 October.
With the percentage change from 3.5 percent to 3 percent being 14.3 percent, one could crudely abstract that future gains are 14.3 percent more valuable to this Government than governments since 2003, which is when the 3.5 percent rate was set.
Yet crude abstractions rarely capture the richness of reality; to get a better understanding of what this change in the discount rate means, it is worth considering it in practice.
Discount Rates in Practice
In the abstract, the reduction of the discount rate is good for those who care about a healthy environment.
The full environmental benefits of a policy are rarely immediate and tend to be dispersed throughout time. This reduction in the discount rate means that those environmental benefits are discounted at a lower rate. Or, in other words, the same environmental policy will be recognised as producing benefits of a higher value.
DEFRA, the Environment Agency and Natural England explicitly adopt the discount rate in the Green Book, although they are not tied to the Green Book rate. These organisations apply their discount rates to a range of environmental policies, including Biodiversity Net Gain (BNG) and Habitat Equivalency Analysis.
There is a common practice within policy circles in which things that lack an obvious or inherent monetary value have a monetary value assigned to them. A common justification for this approach is that it allows for a more inclusive analysis; for example, it allows for the value of nature to be represented when making decisions (whether it is truly possible or appropriate to numerically represent the value of nature is another question).
Consequently, the Office for National Statistics (ONS) produces Natural Capital accounts, which seek to measure the UK’s natural assets and the benefits they provide to people and the economy.
Given that a lot of “natural capital” produces future benefits, due to the discount rate, the value of many of these benefits – including the value of carbon sequestration and flood regulation – is discounted at 3.5 percent per year for the first 30 years of a given policy.
When applied to the woodland capital accounts for the UK, we can see that if we replace the 3.5 percent discount rate with a 3 percent one, then we have an increase in the value of woodland by approximately £29bn to £495bn. It is worth noting that this maths is rough, and that when this new discount rate is applied, there will be other variables which may change the final value, such as the price of carbon.
Consequently, by reducing the discount rate, there has been a gain in the order of billions of pounds to the UK’s natural capital, without there being any change to the physical natural capital.
This point is quite powerful; the fact that the value of natural capital is set to increase has perhaps unexpected implications, and ones which are not necessarily welcome by those who want to see nature’s recovery.
Consider the policy of BNG, which requires a biodiversity net gain of at least 10 percent to be maintained for at least 30 years for many developments when planning permission is required. Given that the benefits BNG occur in the future, the discount rate applies to these projects until the project reaches its target condition. Take Dean Moor, a large solar farm which sought planning permission and sought to comply with BNG requirements (even though it was not a requirement when the application was made). If the BNG calculation for Dean Moor were to be recalibrated using a 3 percent discount rate rather than the 3.5 percent rate, the same proposal could be credited with more biodiversity units. An illustrative recalculation gives approximately 63 units, rather than 56.6 units which were produced under the actual proposal.
This tells us two quite interesting things; the first and well-understood point is that these woodlands are recognised as producing greater benefits when the discount rate is lower. Secondly, and much more counterintuitively, because the per hectare value of each area of woodland has increased, fewer hectares are required to meet the BNG requirements. In other words, by producing a discount rate which effectively holds the benefits of nature in higher regard, the system is such that less nature is required.
It is worth noting that the link between the discount rates used by DEFRA and other environmental regulators is indirect. That is to say, a change in the Treasury’s discount rate does not automatically apply to DEFRA or environmental regulators; they set their own discount rate for their analysis. However, given that these groups have adopted a 3.5 percent discount rate explicitly to reflect the Treasury’s discount rate, it would stand to reason that they would seek to track this rate over time.
When we follow the Budget in October, we are not only discovering which departments get what. We will hopefully hear further clues as to when the Treasury will implement the change to the discount rate, which perhaps closer than any other number, reflects how the Government values the future.