[MUSIC] One of the biggest ethical challenges of valuation and indeed of monetization, is this whole question of discount rate. What discount rate should be used? Today's ecosystem service received today may be worth something. But if we are going to measure the value of the same service received in a years time, maybe five years time, maybe ten years time, maybe after a generation. That's a whole different game. How much is that future service worth today, if we as a policy maker are making the decision to stop it? To destroy it. Or to indeed invest in enhancing it. How do we decide that? That's what the discount rate does. It gives you the ratio of the value of the future, the same thing versus the value today. Let's take an example, 10 Swiss francs. Today it's worth 10 Swiss francs. But if I were to put it into an envelope. And say that well, instead of giving it to you today to buy your lunch, I will give it to you in a year's time. Well, you wouldn't be terribly happy because that's not very useful. But it's fair. Because I'm going to give you an interest rate for one year, which is 20 centimes. So now we have 10 francs and 20 centimes at 2% interest rate. But you might then argue. Well, the inconvenience of going and finding some place to buy because I'm ready to buy lunch downstairs. Okay I say fine, loss of utility I'll give you another 20 centimes, right? So here we have, in this envelope, a 10 franc note for you lunch, in a year's time, sealed, with 40 centimes. So there's a 4% extra sitting in there. The discount factor for this envelope, for it to be worth 10 francs today would be 0.96. You are now happy to take this from me in a year's time, as against taking 10 francs right now. So that what we've done is to show that the discount rate for cash is actually pretty close to an interest rate. But what if I took my lunch, which I have just purchased. Some hot chocolate and a sandwich. And it was worth almost exactly 10 francs. And I said to you well, you can have this now and it's 10 francs. Or let me just put it away for you. There it is, nicely back in its bag. And the hot chocolate which, sorry, won't be that hot in a year's time. And the sandwich, God forbid what it might be in a year's time. And I offer it to you one year forward. Are you comfortable with taking that for 10 francs with just the extra 40 centimes? [LAUGH] I should think not. You won't be able to eat this, and certainly you wouldn't like to drink that in a year's time. That was a goods discount rate. This was a cash discount rate. It's different. That's reality. And by the way, it's not just good and cash that have different discount rates. What about public goods versus private goods, generally? What about goods that are from nature. Versus goods that are made by man? All of these have logical reasons like I just explained in one case, for having different discount rates over the same period of one year. The interest rate really only decides what is the discount rate for cash. Discounting might sound like a simple enough thing to do, but actually as you can see it is pretty complicated. Because there are different kinds of goods and services that can be discounted, which are in different types of ownership. And they come from different sources, whether they are factories on the one hand or nature from the other. Each of these probably deserves its own appropriate discount rate. Other questions also arrive. For instance, can discount rates be negative? Are discount rates and ethical choice? Or is it just something that comes out of a screen on a computer if you click discount rate? These are all good questions to ask. And now let me try and answer. One of the things we have to recognize is that certain discount rates may apply to personal goods, but there could be other discount rates which apply to society. Society's choice of receiving a benefit today versus a year's time, versus 25 years' time. Those are social discount rates. The theory goes that if society made optimal investment decisions rationally. I.e conditions of perfect foresight and other such assumptions. Then the return on investment would be governed by what's known as Ramsey's rule. In other words, the rate of discount or the rate of return on investment would be the sum of two quantities. One is the rate of time preference. In other words, all other things being equal, how much more would I like something today versus in a year's time? And the second in would be the wealth effect. The wealth effect needs a bit of explaining. because what it's saying is that in a society as technology improves, and as progress increases, there will be more goods and services produced in the future. Therefore the marginal utility of the same good would be less. In other words. Would a family be equally pleased with its third television set or its second car, as it was with its second television set and its first car? Will it get the same utility from these third, fourth, fifth items of the same good or service? And the answer is probably not. So that's the wealth effect reason for discounting the future. So, not everyone accepts all of these reasons. In fact, Ramsey himself found the time preference quite unsatisfactory. And he said, It was a practice which is ethically indefensible and arises merely from the weakness of the imagination. Having said that, he still used it in his equation. And this is something that is still used quite consistently by economists when they measure and model discount rates. But let's take Ramsey's equation and see what would happen if, instead of measuring manufactured goods and services, we are now measuring nature's goods and services. Because unlike the factories of man, unlike the investment of man which will probably produce more cars and more television sets in the future. We know that due to the lose of ecosystems and biodiversity, there aren't going to be more ecosystem services being produced into the future. How then can we assume that there should be a positive discount rate using the wealth effect, when in fact we’re going to be less wealthy in terms of natural goods and services? The free goods and services that come from nature. Ecosystem services. So on that logic you might argue that for the goods and services of nature, you ought to use a negative discount rate. Reflecting the increased scarcity in the future, not the increased abundance in the future. Another dimension of discounting is the marginal utility of $1 or 10 Swiss francs to a normal person in a normal context. Versus someone who's extremely rich or someone who's extremely poor. They would have probably no marginal utility for 10 francs if they were too rich. If they were very poor, they would probably have have high marginal utility for the same 10 francs. Because they could feed themselves for several days, not just one lunch. We need to take that into account, when we apply discount rates across different socioeconomic contexts. Because the same dollar is not got the same utility or the same value. For different societies, different communities at different stages of economic and social development. When it comes to intergenerational equity, it's interesting to see what typical research tends to suggest in terms of interest rates. And it's interesting to see what that means in ethical terms. The TEEB'study in 2008, collected many valuation studies. And the typical discount rates that were being used there were between 3 and 5% in most cases. In other words let's say an average of 4%. Not dissimilar to the coin that I had to compensate you for the 10 francs that I gain. Now, that might appear to be a reasonable discount rate. However, if you think about intergenerational equity. In other words, taking a decision of trading off a piece of nature today, with its ecosystem services outside the city, or close to the national park, or wherever. That decision will affect future generations. And if you apply the discount rate of 4% on a compounded basis for 25 years, and then 50 years. Let's say my grandchild. You come to a discount factor which is 0.14. In other words, what I'm saying, by stopping an ecosystem service today, which could be of value to my grandchild. When I trade that off using a discount rate of 4%, I'm ascribing to her one-seventh the value that I ascribed to myself. Excuse me, I have two daughters and I think they will have children. I don't think I dare do such a thing. I think it would be hopelessly unethical for me to suggest a discount rate of 4%. Trading off the benefits that I enjoy versus the same benefits that my granddaughters would be entitled to enjoy in 50 years time. That's all about ethics. It's an ethical choice, that 4%. You could take the view that it shouldn't be 4%, it should be 0%. Or you could indeed take the view, given scarcities and the wealth affect of Ramsey's equation. That it should be a negative rate and not a positive rate. In other words, as I hope I have been able to convince you, discounting might sound simple but actually it's pretty complex. And it's quite rich in ethical content. We need to recognize that there are no purely economic answers. There is no button that you can press and get an answer out of a machine for a discount rate. And that it is an ethical choice. We need to recognize that there is a degree of responsibility towards future generations, when it comes to intergenerational discounting. And a degree of responsibility towards other people on the planet, when it comes towards lateral discounting. As in providing discount rates for poorer communities versus us. And finally, we need to recognize that there are a whole variety of discount rates that are possible. This can get extremely complicated when for instance you are making a policy decision between one course of action that generates private profit. And another course of action over time, the same period, let's say 25 years, that generates public benefits. Because potentially you could be using two different discount rates for these two different courses of actions. And please, it's not the world of finance that tells you that you can't. I am from the world of finance, I have placed any number of cross currency swaps. I've always use two different currency discount rates for pricing the two legs of that swap. So this is very much part of economic thinking, financial thinking. That we can and should be conscious of what we're discounting, at the time that we apply discount as a means of valuation. [MUSIC]
