Some assets are overused or underprovided - why?

Complications arising from long time-horizons and uncertainty

One of the difficulties with environmental problems is that the costs and benefits of addressing the issue are sometimes highly uncertain. The problem is even more complicated when the costs and benefits are realized at different points in time-often benefits materialize in the long term while costs are incurred in the short term, as with climate change. Sometimes the costs and benefits that occur in the future at different points in time can be discounted or converted into an equivalent set of costs and benefits today, using the consumption rate of interest-the rate at which consumption tomorrow can be substituted for consumption today without changing social well-being. But the farther the benefits occur into the future, the greater the bias toward inaction, because discounting automatically reduces the valuation of these benefits.⁷⁴

However, if one recognizes that a longer time- horizon also means that there could be significant uncertainty about the interest rate itself, and if the cost-benefit analysis takes this uncertainty into account, the valuation of benefits over distant horizons increases. (Since the consumption rate of interest depends in part on the forecast of future consumption, uncertainty about long-run economic forecasts would imply an uncertainty about the interest rate.)⁷⁵ As a nonrigorous but illustrative example, an exercise allowing for such uncertainty looked at the benefits of addressing climate change. Using the government bond rate (generally taken to be the best proxy for the consumption rate of interest) of 4 percent as the initial rate, the study assumed that future rates could either rise to 7 percent or fall to 1 percent, and showed how allowing for this uncertainty could add about 80 percent to the expected present value of addressing climate change (carbon mitigation) relative to the valuation under a constant interest rate of 4 percent.⁷⁶ Thus, if a dollar's worth of benefits in the future is worth 25 cents under a constant interest rate of 4 percent, it would be worth 20 cents more (45 cents) allowing for this uncertainty in interest rates.

Reducing uncertainty generally requires the generation of knowledge and information. The possibility of hitting thresholds also highlights the importance of developing and monitoring key indicators that can signal coming problems. Unfortunately, as discussed earlier, such knowledge and information is also usually underprovided because individuals, in deciding whether to invest in knowledge and information gathering, do not take into account the positive spillovers that this can generate for society.