Economists: Long-term investments can become more equitable

ECONOMY Two economists have developed a new way of looking at equity between later and earlier generations in the long-term investments we make as a society in areas such as climate change. The new theoretical framework could make it easier to balance the interests of the present and the future, ...
Three generations sitting on a bench
Photo: Askar Abayev, Pexels

When we discuss climate action, pension reforms or investments in technology, we are really talking about one big question: How should we distribute benefits and costs between generations?

In a new study, two economists from the University of Copenhagen and the University of St. Gallen have created a groundbreaking framework for understanding and assessing this very question.

‘We distinguish between two key considerations that are often confused: how we weigh future versus present generations, and how we deal with inequality between generations. We are the first who have managed to do this for all possible attitudes towards time and inequality,’ explains Frikk Nesje, associate professor at the Department of Economics at the University of Copenhagen.

A modular view of justice

The researchers introduce what they call modular approaches to intergenerational justice. This means that attitudes towards time and inequality can be analysed and adjusted separately – as two separate modules:

What is the social discount rate?

The social discount rate determines how much less we value future gains or losses compared to those we experience today.

Because we generally prefer to get something good now rather than later, economists discount the value of future consequences – e.g. from climate action – by a rate. This is called time discounting.

Another reason is inequality aversion. If future generations are expected to be richer than us, economists discount the value of future consequences.

The method is used in cost-benefit analyses to determine how much it is worth investing today to achieve benefits far into the future.

‘Time discounting is about how much less we value the welfare of future generations compared to the present,’ explains Frikk Nesje, continuing:

‘The inequality module is about how much we care about differences in welfare between generations – for example, between a poor present and a richer future. Whereas previous theoretical frameworks only focus on differences in welfare levels between generations, we can let attitudes depend on the entire intergenerational distribution of welfare.’

By separating these two dimensions – which have often been mixed together – we can avoid unintended biases and get a more accurate picture of the values that actually underlie political decisions. Attitudes towards time and inequality can also be adjusted to better reflect people's views on the issue.

The theoretical framework is based on a technical innovation that converts calendar time into so-called equivalent time by lengthening or shortening the time axis. Normally, in other theoretical frameworks – such as those used by the Ministry of Finance in cost-benefit analyses – the value of future welfare is adjusted downwards by discounting and calculating present values. The new study's approach is to maintain the level of welfare and instead adjust the time axis.

‘The new approach works like this: with time discounting, it is as if future people live shorter lives. This insight can be used to adjust the time axis so that, in principle, all points in time are assigned the same value. This makes it possible to compare the welfare of different generations more fairly,’ says Frikk Nesje.

It is this way of thinking that opens up new possibilities. Precisely because the level of welfare itself does not change, it is easy to express attitudes towards greater equality in welfare between generations.

‘For the first time, it is also possible to express measures for the distribution of welfare between generations, such as the Gini coefficient. The study also has results on how the balance between the total distributed welfare – the size of the cake – and the fairness of the distribution – the split of the cake – can be assessed,’ says Frikk Nesje.

New tools for political analysis

The economists believe that almost all existing theories on intergenerational justice – including the classic ‘Ramsey rule’ found in the Ministry of Finance's guidelines on cost-benefit – can be understood as special cases of their new modular approach. But more importantly, the new theoretical framework opens up previously overlooked simple combinations that may be both better and more realistic.

What does the discount rate mean in practice?

Imagine that society is considering investing 1 billion DKK in a climate project that will only have its full effect in 100 years – e.g. by reducing emissions or preventing flooding.

If we use a social discount rate of 5%, the value of the future gain today would be very low – only around 7.6 million DKK. This means that we are assigning a low value to future generations.

But with a discount rate of 1%, the same future gain is estimated at approximately 370 million DKK today. This makes it much more attractive to invest in the future – and reflects a greater emphasis on the needs of future generations.

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‘The new approach can be used to calculate a social discount rate that takes into account both time and inequality – and thus provides a more nuanced basis for climate calculations, for example,’ emphasises Frikk Nesje, adding:

‘At a time when we are assessing long-term investments in climate, it is crucial to have clear and transparent principles for how we assess future consequences.’

The researchers believe that their theoretical framework can help decision-makers make more ethically informed choices – and avoid unintended biases.

‘Our approach makes it possible to reflect the values that people actually hold – and not just those that are easy to calculate,’ concludes Frikk Nesje.

The study, entitled ‘Intergenerational Discounting and Inequality’, was written by Frikk Nesje in collaboration with Paolo G. Piacquadio. You can read it here.

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