The Kyoto Protocol offers three platforms to mitigate the climate change problems i.e. emission trading (ET), joint implementation (JI), and clean development mechanism (CDM). The protocol is a cap-and-trade system where every ratifying country is given emission limit (the “cap”) and then each country can trade their emission rights. ET is a market mechanism (similar to stock exchange market) to host emission trading, while the JI is a mechanism for industrialized countries to get emission credits by investing in emission reducing projects in another industrialized countries. The CDM is similar to JI only that CDM participants come from industrialized and developing countries.
The protocol implies that countries (and ultimately, firms) have to invest in cleaner production method either in the countries itself or in another countries and to invest in emission reducing projects such as forestation. Firms, under neoclassical approach (and to some extent, other non-neoclassical approach) are profit seeker and therefore firms see climate change initiatives as investment projects.
Investment analysis involves concept of Time Value of Money (TVM). In brief, the TVM implies that money value is changing over time where present money value is greater than future money value (unless deflation happens continuously over time, which is very unlikely to happen). The future benefits and costs are discounted to the present in order to get its net present value (NPV).
Where: t = time; B = benefit; C = cost; r = discount rate.
By analyzing the mathematical formula, we know that the NPV is depended on three factors, i.e. the amount of benefits and costs, the time, and the discount rate. While costs are in present time (sometime it is simplified as ‘initial investment’), net benefits are in future time. Therefore, the effect of discounting mostly affects the net benefits. The effect of discounting is composed by t and r. The longer the time period (t), the bigger is the discount factor. The bigger the discount rate (r), the greater is the discount factor.
Although the TVM is perfectly acceptable in evaluating pure economic investments however, its usage in evaluating environmental investments should be questioned. The first reason is that the property of environmental investments is not only of economic value but also non-economic value such as quality of life and human life itself. The fundamental debate in using discounting for environmental projects is how we measure non-economic value (e.g. a human life) to an economic value (e.g. is life for sale?).
To put it simple, suppose we know that a forestation project will prevent a land-slide to small village with no economical benefits to a logging firm whilst without the forestation, the land-slide will kill some of villagers. The firm seeing the project as not profitable (only as cost) may then reject the project implementation. Having arrived in this point, we conclude that according to the firm the value of some villagers’ life is much less than the forestation costs. The debate then shifted into whether this behaviour is acceptable. Anther simplified example is that under discounting principle, the present value of 100 lives in 10 years time and 1% discount rate is only 90 lives. Ten lives are discounted and ignored. Is this behaviour ethical?
The discounting principle is a delicate matter to apply in climate change initiatives also due to initiatives’ transboundary nature of benefits and costs. The main question is what is the proper discount rate in evaluating climate change initiatives that applies globally? Up to the moment there is no commonly agreed discount rate for this matter. Different countries and companies have their own discount rate. It is logical that an emission reducing project is rejected in a country while it would have been accepted in another country.
The second reason is that the property of environmental problems is the irreversibility. It means that some environmental damages cannot be undone e.g. species extinction. Meanwhile, most of damages or benefits happen in the future (hence the temporality of the problems) and its possibility to occur is uncertain (hence the uncertainty of the problem risks). Therefore we should treat the discounting principle with care especially when compared to precautionary principle of Agenda 21 (Principle 15).
Therefore, any environmental project evaluation should involve an integrated analysis of social-environmental-economical benefits and costs. The analysis must seek a balance of those three aspects. Failure to do so may lead to a further damage in longer period. For example a pure forest conservation (thus putting attention only on environmental benefit) may marginalise villagers (as they cannot access to the forest products, and thus worsening social aspect) and may ignore economic value of forest products.
Although the essay does not advocate a novel approach to deal with the problem of discounting in climate change however, it encourages the usage of an integrated analysis to give a more comprehensive picture of the climate change initiative’s value. Furthermore the essay argues that a pure discounting practice may become unethical in assessing environmental projects.
Houghton, J.T., Ding, Y. , Griggs, D.J., Noguer, M. , van der Linden, P.J., Dai, X., Maskell, K., Johnson, C.A. (2001) Climate Change 2001: The Scientific Basis, Contribution of Working Group I to the Third Assessment Report of the Intergovernmental Panel on Climate Change, IPCC, Cambridge University Press.
 The example is an extreme simplification of real conditions.
 We can also say that the land-slide is as the effect of high precipitation caused by global warming.
 This kind of debate is prominent in the scope of Corporate Social Responsibility.
 Usually firms’ discount rate (or required return) is generated from its financing structure, debt interest rate, risk and expected market return. Meanwhile governments use Social Time Preference by comparing utility over time and generations to generate the discount rate.
 The precautionary principle demands that “where there are threats of serious or irreversible damage, lack of full scientific certainty shall not be used as a reason for postponing cost-effective measures to prevent environmental degradation”.