Intertemporal Equity, Discounting, and Economic Efficiency in Water Policy Evaluation

This paper addresses how the inclusion of global climate change may affect the discounting procedures used to evaluate water resources programs and projects. The primary document governing water resource planning and evaluation today is the Principles and Guidelines (P&G) adopted by the Water Resource Council in 1983. The issue is whether the P&G and related planning rules needs to be revised with regard to discounting and the choice of the discount rate in response to changing conditions associated with potential climate change and in light of the chapter on intertemporal equity, discounting, and economic efficiency from the report by the IPCC (IPCC, 1996c, ch. 4).Section 2 lays out the basic methodology of cost-benefit analysis and traces the development of issues pertaining to the choice of the discount rate. It is important to consider the discount rate issue in the context of the theoretical foundations of cost-benefit analysis and in particular, the Kaldor-Hicks compensation test. Section 3 sets out what the IPCC chapter on discounting (IPCC, 1996c, ch. 4) describes as the descriptive approach versus the prescriptive approach to choosing a discount rate. It examines the rationales which economists use to support the argument that the discount rate for evaluating public projects should be lower than the marginal rate of return on private investment. It also describes the challenges that using a lower rate poses for the economic evaluation of alternative public projects including water projects. Section 4 addresses the issue of intergenerational equity as it relates to global warming and to discounting and discusses the extent to which issues of intergenerational equity can be accounted for by lowering or raising the discount rate.Section 5 discusses the importance of dynamic flexibility. Section 6 briefly addresses the question of whether the water resources planning process should extend the multiobjective framework to incorporate a full multiobjective criterion function for inclusion in a revised P&G for the future. The final section of the paper sets forth the major conclusions to be drawn from this analysis and from the chapter on intergenerational equity, discounting, and economic efficiency of the IPCC report (IPCC, 1996a ch. 4) for the planning and evaluation procedures in the P&G. Because of the complexity of the outstanding issues regarding the discount rate and of the practical difficulty of applying procedures designed to capture all of these complexities a discounting rule is proposed that this writer believes will improve the overall efficiency of water resource decisions. Whichever procedure described in this paper is finally chosen, the current discounting rule will have to be revised.