Tuesday, January 5, 2016

Climate Change and Long-Run Discount Rates: Evidence from Real Estate

The optimal investment to mitigate climate change crucially depends on the discount rate used to evaluate the investment’s uncertain future benefits. The appropriate discount rate is a function of the horizon over which these benefits accrue and the riskiness of the investment. In this paper, we estimate the term structure of discount rates for an important risky asset class, real estate, up to the very long horizons relevant for investments in climate change abatement. We show that this term structure is steeply downward-sloping, reaching 2.6% at horizons beyond 100 years. We explore the implications of these new data within both a general asset pricing framework that decomposes risks and returns by horizon and a structural model calibrated to match a variety of asset classes. Our analysis demonstrates that applying average rates of return that are observed for traded assets to investments in climate change abatement is misleading. We also show that the discount rates for investments in climate change abatement that reduce aggregate risk, as in disaster-risk models, are bounded above by our estimated term structure for risky housing, and should be below 2.6% for long-run benefits. This upper bound rules out many discount rates suggested in the literature and used by policymakers. Our framework also distinguishes between the various mechanisms the environmental literature has proposed for generating downward-sloping discount rates. 
The expected return on real estate is 5.9%, just below our empirical net return estimates between 6.4% and 8.0%. Expected rent growth is 1.6%. Our calibration implies that returns as well as rent growth are about as volatile as equity, with 8.2% and 14.2%, respectively. In line with our empirical findings, rental yields contribute more than two thirds to total returns. The term structure of discount rates for real estate is downward sloping as shown in Panel B of Figure VII. It falls from 17.8% for claims to one year ahead rents, to 3.9% for claims to rents one hundred years ahead, all the way to 2.3% for one thousand year ahead rents
[The] upper bound is lower than numerous estimates used in the existing literature and by policymakers for discounting investments in climate change abatement. For example, it is substantially below the 4% suggested by Nordhaus (2013) and the 4.6% suggested by Gollier (2013). Quantitatively, it is more in line with long-run discount rates that are close to the risk-free rate, as suggested by Weitzman (2012), or the 1.4% suggested by Stern (2006)31, or results by Barro (2013). It is also close to the average recommended long-term social discount rate of 2.25% elicited by Drupp et al. (2015) in a survey of 197 experts, and falls within the range of 1% to 3% that more than 90% of these experts are comfortable with. At the same time, while some authors have proposed low long-run discount rates for climate change abatement, the theoretical arguments underlying these proposals vary widely, and some are at odds with our empirical evidence....

In light of the general disagreement in the literature regarding the appropriate discount rate, the interagency group tasked by the U.S. government to value reductions in CO2 chose three certainty-equivalent constant discount rates: 2.5%, 3%, and 5% per year. Our estimates provide a tight bound that is only consistent with the lowest rate of 2.5% for investments providing a long-run hedge against climate disasters. Greenstone, Kopits and Wolverton (2013) report the cost of 1 metric-ton of CO2 to be $57 when using our suggested 2.5% discount rate, but only $11 when using a 5% discount rate, illustrating the impact of this bound on climate-change-related welfare calculations (see also Pizer et al., 2014)

Technical Guidelines For Resilience House Construction To Climate Change 
by Stefano Giglio, Matteo Maggiori, Johannes Stroebel and Andreas Weber
National Bureau of Economic Research (NBER) www.NBER.org
NBER Working Paper No. 21767; Issued in November 2015

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