Many important policy decisions require a consideration of costs and benefits that arise in the distant future. For example, many of the costs of climate change occur 100 or more years from now, yet actions to reduce greenhouse gas emissions have to be taken today to avert those long-run costs. In recent weeks, the Intergovernmental Panel on Climate Change mitigation report, or UN climate change report, presented and discussed different options for reducing such emissions, but contended that “most mitigation strategies have costs in the present and yield benefits in the future. Policy making involves assessing the values of these benefits and costs and weighing them against each other.”
A crucial step in evaluating distant costs and benefits is the choice of an appropriate discount rate. How much do individuals value cash flows that arise hundreds of years from now and will accrue to future generations? The literature on environmental policy has long focused on the importance of these long-run discount rates in assessing the benefits of policies such as reducing carbon emissions (Weitzman 2001, 2013, Barro 2013, Gollier 2012, Pindyck 2013). For example, Stern (2007) calls for immediate action to reduce future environmental damage based on the assumption of very low discount rates, arguing that while agents discount the future over their lifetimes, they have an ethical impetus to care about future generations. This assumption has been criticised amongst others by Nordhaus (2007), who points out that the private return to capital is 4-6%.
Much of this disagreement about the appropriate long-run discount rate is driven by the fact that little direct empirical evidence exists on how households actually discount payments over very long horizons because of the scarcity of finite, long-maturity assets necessary to estimate households' valuation of very long-run claims.
Estimating valuations of very long-run (but finite) assets
In Giglio, Maggiori and Stroebel (2014), we provide direct estimates of households' discount rates for payments very far in the future, by studying the valuation of very long (but finite) assets. We exploit a unique feature of residential housing markets in the UK and Singapore, where property ownership takes the form of either very long-term leaseholds or freeholds. Leaseholds are temporary, pre-paid, and tradable ownership contracts with maturities ranging from 99 to 999 years, while freeholds are perpetual ownership contracts. The price discount for very long-term leaseholds relative to prices for otherwise similar properties that are traded as freeholds is informative about the implied discount rates of agents trading these housing assets. This allows us to gather information on discount rates much beyond the usual horizon of 20-30 years spanned by bond markets.
Our empirical analysis is based on proprietary information on the universe of residential property sales in the UK (2004-2013) and Singapore (1995-2013). These data contain information on transaction prices, leasehold terms, and property characteristics such as location and structural attributes. We estimate long-run discount rates by comparing the prices of leaseholds with different maturities to each other, and to the price of freeholds across otherwise identical properties. We use hedonic regression techniques to control for possible heterogeneity between leasehold and freehold properties; this allows us to identify price discounts associated with differences in lease length.
Figure 1. Estimated leasehold discounts for the UK
Figure 1 presents estimates from the UK of the log difference in prices between leaseholds with varying remaining maturity at the time of sale and otherwise identical freeholds. Leaseholds with 80-99 years remaining are valued about 15% less than otherwise identical freeholds; leaseholds with maturity of 100-124 years are valued 10% less than freeholds. In other words, households attach substantial present value to owning the housing asset in 100 or 125 years. There are no price differences between leaseholds with maturities of more than 700 years and freeholds.
In Giglio, Maggiori and Stroebel (2014), we document how the differences in prices be