Groom, B; Koundouri, P; Panopoulou, E; Pantalidis, T; (2004) Model selection for estimating certainty equivalent discount rates. (Discussion Papers in Economics 04-02 ). Department of Economics, University College London, UCL (University College London), Department of Economics, University College: London, UK.

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Abstract

In a recent paper, Newell and Pizer (2003) (N&P) build upon Weitzman (1998, 2001)and show how uncertainty about future interest rates leads to ?certainty equivalent? forwardrates (CER) that decline with the time horizon. Such Declining Discount Rates(DDR?s) have important implications for the economic appraisal of the long-term policyarena (e.g. climate change) and inter-generational equity. This paper discusses the implicationsof N&P?s transition from the theory to practice in the determination of theschedule of discount rates for use in Cost Benefit Analysis (CBA). Using both UK &US data we make the following points concerning this transition: i) to the extent thatdifferent econometric models contain different assumptions concerning the distributionof stochastic elements, model selection in terms of specification and ?efficiency criteria?has important implications for operationalising a theory of DDR?s that depends uponuncertainty; ii) mispecification testing naturally leads to employing models that accountfor changes in the interest rate generating mechanism. Lastly, we provide an analysis ofthe policy implications of DDR?s in the context of climate change and nuclear build inthe UK and the US. In a recent paper, Newell and Pizer (2003) (N&P) build upon Weitzman (1998, 2001)and show how uncertainty about future interest rates leads to ?certainty equivalent? forwardrates (CER) that decline with the time horizon. Such Declining Discount Rates(DDR?s) have important implications for the economic appraisal of the long-term policyarena (e.g. climate change) and inter-generational equity. This paper discusses the implicationsof N&P?s transition from the theory to practice in the determination of theschedule of discount rates for use in Cost Benefit Analysis (CBA). Using both UK &US data we make the following points concerning this transition: i) to the extent thatdifferent econometric models contain different assumptions concerning the distributionof stochastic elements, model selection in terms of specification and ?efficiency criteria?has important implications for operationalising a theory of DDR?s that depends uponuncertainty; ii) mispecification testing naturally leads to employing models that accountfor changes in the interest rate generating mechanism. Lastly, we provide an analysis ofthe policy implications of DDR?s in the context of climate change and nuclear build inthe UK and the US.

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