Discounting the Future, Climate Risk, and MCC’s Focus on Results

The Millennium Challenge Corporation (MCC) has earned a reputation for its strong focus on results, which informs everything from country selection to the robust evaluation of project impacts. One of the bedrocks of MCC’s results orientation is its requirement that its projects achieve high economic rates of return (ERRs), in keeping with MCC’s mission to reduce poverty through economic growth. But ERRs are not the only criterion for investment. Projects must also meet strict environmental standards and demonstrate sustainability, country ownership, and gender inclusion. Sometimes there can be tradeoffs between growth and these other requirements. But as long as projects are expected to meet MCC’s ERR hurdle rate of 10 percent, further economic returns can be traded off against these other objectives.

MCC recognizes that maintaining results at the center of its policies and practices requires a continual effort to learn and consider new knowledge, evidence, and experience. MCC should continue to take its analytical tools seriously and ensure that its economic analyses are fit for purpose. That may mean taking into account dynamic and distributional considerations, the potential impacts of policy and institutional reform, and the growth effects of environmental damage. This will only help the agency allocate resources to the best uses in achieving its mission.

Recently, conversations sparked in part by the global challenge of climate change have turned to the topic of MCC’s intertemporal discount rate—the rate at which future benefits and costs are discounted relative to the present. Although MCC’s discount or hurdle rate may seem an arcane and technical issue, downward changes to either would likely have broad implications for the agency’s results-driven model. Any change in policy should be taken in light of the risks to the agency’s focus on fulfilling its mission of poverty reduction through growth.

MCC and climate change

It is well known that climate change promises to be especially detrimental to economic activity in poor countries, like those where MCC operates. MCC has long taken climate change and other environmental considerations into account in its project due diligence. And over the last five years (FY2015-FY2020), the agency invested roughly 40 percent of its program funds in climate-related activities. MCC’s new climate change strategy—released last year—raises the agency’s ambitions, committing to allocate more than half of its program funding to climate-related investments over the next five years. The new strategy also represents an effort to refine and build on existing practices to incorporating climate change into MCC’s work. But as the strategy is further elaborated, it has prompted new questions about how a more intentional climate focus might square with the agency’s ERR investment criterion and discount rate.

Economic analysis at MCC

MCC assesses the economic merits of a proposed intervention by weighing its total costs against the economic benefits expected to occur in its partner countries. But because costs and benefits accrue over time, arriving at a summary metric requires that future costs and benefits be discounted relative to today’s. Future values are worth less to societies for two reasons. First, people prefer consumption (or utility) today over consumption tomorrow. And second, investments today yield benefits—a positive return on investment—in the future, regardless of society’s intertemporal preferences. If a project does not provide benefits that exceed its costs, this represents a social loss: scarce US taxpayer and country resources could have been directed to better uses.

In principle, MCC should discount the future according to the social discount rate of the countries where it works. But while the “true” social discount rate is always greater than zero, it is very difficult to estimate and it varies from country to country. Given this difficulty, after some years of experimentation, MCC eventually adopted a single, 10 percent hurdle rate and implicitly set its discount rate equal to it. Although inevitably arbitrary, 10 percent was in line with or lower than rates used by other development agencies and had the virtue of simplicity. Although MCC’s main economic decision metric has always been the ERR, the agency also reports net present values of its projects in congressional and other reporting, and this requires the use of an explicit discount rate, which may not necessarily equate to the hurdle rate. But because the ERR is computed as the discount rate at which the net present value of social costs and benefits equates to zero, using the hurdle rate as the discount rate made sense for consistency of communication.

Does MCC’s discount rate adequately capture climate considerations?

In the climate domain, the policy community has raised a general concern that current and past generations have not taken sufficient account of the costs of growth to future generations—that societies have discount rates that are too high to preserve the climate. There appears to be an emerging trend among climate action organizations and high-income country governments to utilize a lower social discount rate to inform climate-relevant policies like environmental regulation and energy investments.

As a result, MCC’s Economic Advisory Council—a group of external experts who provide the agency independent advice on methodological and other economic issues—advised that MCC may want to consider lowering the discount rate it uses to better capture these longer-term benefit streams.

The risk, however, is that such a change could lead the agency to devote more of its resources to investments without near-term benefits for people living in lower-income countries who are in desperate need of economic opportunity. A lower discount rate across the board could even mean that this could occur without any accompanying climate or other future benefits at all. Placing less emphasis on helping the current generation is problematic, since MCC countries bear little to no responsibility for the current climate crisis. Furthermore, as argued below, the technical merits of the aurgment for MCC to lower the discount rate do not appear well founded.

The theory—and reality—behind discount rates

One of the theoretical arguments to support the use of a lower discount rate is that it should be predicated primarily on the rate of time preference (RTP), a subjective measure that captures how a society (or person) prefers to trade off consumption (or utility) in the present versus the future. In some formulations, an increment is added to the RTP to adjust for expected growth. In high-income countries, where most people can meet their current needs, these approaches have resulted in social discount rates in the mid-single digits. So, some have also argued that development agencies should lower their discount rate to around 5 or 6 percent (or even lower, in which case they would cease to be much of a screen at all).

However, the discount rates an organization uses should also reflect the objectives of that institution and its projects. While lower discount rates may be appropriate for agencies like the US Environmental Protection Agency, which make regulations and assess US-based programs, it would be unusual to argue that people living in poverty, struggling to meet their minimum, immediate needs, much less invest in their children’s future, would have such a low RTP. On the contrary—to them, income today is an urgent issue. It is not at all clear that their RTP would be below 10 percent.

But just as there are two reasons for discounting the future, there are two valid bases for establishing a social discount rate. In addition to the RTP, one can use the social opportunity cost of capital (SOCC)—the rate of return to society that is available through alternative policies or investments. In theory, if markets are perfect, this will equal the RTP, but in reality, it does not. To be sure, using the SOCC approach may be too traditional to suit today’s understanding of the world’s problems. But for economic development programs like MCC’s that are designed to raise incomes, the SOCC is the more appropriate foundation.

Regardless of a society’s RTP or a country’s expected growth rate (which, in lower-income countries, is often low, especially now with pressures from the pandemic and conflict in Ukraine), a society is not made better off when it invests scarce resources in a project that yields a low return. This is true even if that society does not discount future consumption at all. The reason is simple. If there were two investments that paid the same nominal dividend, with the one paying that dividend earlier and one later, by electing the earlier payment, income could be saved for the future in keeping with society’s RTP. Then, regardless of the RTP, both current and future consumption would increase.

In fact, whether a society bases its policies on the RTP or the SOCC should depend upon which rate is higher and what possibilities exist for either saving for or borrowing from the future. If the rate of return to available policies and investments (the SOCC) is higher than the RTP, it would still be better to invest in the higher return alternatives and save (and reinvest) some portion of those returns for future generations. Indeed, that is what people living in poverty often do: once they have some minimum standard of living, they invest in their children’s education, farm implements, and businesses; they build the foundation for future generations to reinvest in their children as well. But it is very difficult for people living in poverty to borrow from the future to invest in their businesses, farms, or children.

The SOCC is, moreover, likely to be high in low-income countries where MCC operates. In economies that are relatively rich in capital, such as Sweden or the United States, the average SOCC is generally thought to be low. But in low-income economies, capital is scarce, as signaled by higher interest rates; if capital can be well directed, the opportunity cost for its use is high. Public investments and policy reforms that seek to address binding constraints to growth—as MCC’s projects do—would, in principle, have high returns. So, for MCC, it is imperative to allocate resources to higher return uses. Lowering standards for economic returns would not help it achieve this.

Indeed, social discount rates may not be the core constraint to more and better climate investment

Ultimately, our collective failure over the years to account for climate protection in our policies and investment models may not stem from inappropriate discounting of future consumption at all. If that were the case, it would be difficult to explain why global wealth has grown as societies have invested and incomes and consumption have risen. Rather, the world has collectively struggled to recognize and support global public goods (GPGs), including a stable climate. As with other GPGs, climate protection poses the added difficulty of predicting when, where, and to what extent climate change effects will be felt. Perhaps more important than adjusting its discount rate would be for MCC to adopt a global view of the costs and benefits of its interventions, as long as its main focus remains on raising the living standards of MCC countries.

Ultimately, a lower threshold may risk lowering the agency’s standards or revising its mission

Despite the abstruse nature of the topic, the question of whether MCC should lower its discount rate—whether for climate-related programs alone or across the board—is not an incidental one. Lowering the expectation of growth benefits by reducing the ERR hurdle rate for all or part of the agency’s funding would represent a major change in focus and diminish the overall quality of MCC-funded programs. And because the realized impacts of a project are uncertain, the lower the acceptable estimated ERR, the higher the likelihood that these returns will approach zero or even turn negative. 

Investing in programs with low estimated ERRs can be justified for governments or organizations with different objectives. Some programs—like those focused on temporary relief, redistribution, climate, biodiversity, or cultural advancement, for example—may have low ERRs but be highly desirable. Organizations that prioritize these types of goals may legitimately wish to strike different tradeoffs than MCC. But MCC’s mission is centered on prioritizing sustained, broad-based economic growth as a necessary driver of many desirable social developments; its tools should reflect that. Projects with lower expected returns, whether or not they have important climate benefits, will deliver benefits to the poor that are fewer, later, or possibly nonexistant. It is difficult to see why people living in poverty—or MCC—would prefer that.

The way forward

All indications are that MCC can pursue growth with climate-friendly programs simultaneously. As noted above, between FY2015 and FY2020, with a hurdle (discount) rate of 10 percent, MCC still managed to devote 40 percent of its program funds to climate-related investments—even without intentional prioritization. The degree to which the 10 percent hurdle may have caused the agency to reject possible climate-sensitive projects or adaptations is unclear. In fact, there are likely to be few projects that MCC would consider that would have major tradeoffs between longer-term climate health and shorter-term income generation. Investments in nonrenewable energy may be one such area, but as long as projects achieve a 10 percent expected return, there is nothing barring MCC from investing in a more renewable or cleaner energy mix. Energy poverty is a significant problem in most of the countries in which MCC operates; where lack of electricity is a binding constraint to growth, the returns on MCC investments in this area, especially if accompanied by the appropriate energy sector reforms, tend to be very high. And with the cost of renewable energy declining relative to fossil fuels, the historic tradeoffs around cost are less pronounced. In countries where energy sectors may be shifting from dirtier fossil fuels to natural gas, but less so to renewables, there might be more direct tradeoffs to consider. But as long as growth impacts were substantial, MCC can help countries pivot to cleaner energy and pursue its growth-oriented mission responsibly without lowering its hurdle or discount rate. In other cases, such as in energy efficiency projects, there is no tradeoff between current economic returns and the climate.

MCC has based its reputation, in part, on its dedication to high-return projects. This needs to be protected and reinforced as part of a welcome return to a science-based perspective on climate. Though MCC should maintain a discount rate policy that reinforces its growth-oriented mission and be wary of lowering this rate, there are other approaches MCC can use to better incorporate climate considerations into its economic analysis and project design, many of which it is already pursuing:

• Work with experts in climate modeling to develop and incorporate fulsome estimates of climate impacts on growth and welfare—including catastrophic risks—of MCC interventions.
• Incorporate the costs and benefits of climate adaptation and mitigation into those of a larger program with the same ultimate growth objectives. Features introduced to make a project more climate smart can be blended into a larger growth-oriented project or activity to achieve an overall rate of return that exceeds 10 percent.
• Develop a case history of instances where MCC finds that it cannot support climate mitigation or adaptation as an element of its investments within these parameters and then analyze and revisit the investment criteria that should be applied, without weakening this criterion for the agency’s whole portfolio.
• Consider valuing certain global public goods that have important indirect but important impacts on growth but that have historically not been included in the ERR calculation, such as climate stability. Criteria could include irreversibility and risks imposed on the poor worldwide.
• Permit (only) well justified inconsistencies or implicit double discounting techniques such as counting the “price” of carbon emissions as they occur, whether this price may be estimated using a globally lower discount rate. But ensure that the real income benefits to poor countries comprise the main share of economic benefits of its programs.
• Extend the timeframe of analysis: When relevant, MCC can and does extend the timeframe for analysis to account for high costs or benefits for future generations.

And finally, as MCC considers how to update its analytical tools to better reflect long-term and diffuse benefits—including those related to climate—it should do so in an open and consultative fashion. After all, questions of discount rates are not “settled science”; there’s plenty of room for debate—as long as these discussions stay focused on MCC’s central goal of poverty reduction through economic growth.

Theresa Osborne is Senior Labor Economist at the World Bank. Until 2019 she served as Deputy Chief Economist and Managing Director for Economic Analysis at the Millennium Challenge Corporation.