Model selection for estimating certainty equivalent discount rates

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’ forward rates (CER) that decline with the time horizon. Such Declining Discount Rates (DDR’s) have important implications for the economic appraisal of the long-term policy arena (e.g. climate change) and inter-generational equity. This paper discusses the implications of N&P’s transition from the theory to practice in the determination of the schedule 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 that different econometric models contain different assumptions concerning the distribution of stochastic elements, model selection in terms of specification and ‘efficiency criteria’ has important implications for operationalising a theory of DDR’s that depends upon uncertainty; ii) mispecification testing naturally leads to employing models that account for changes in the interest rate generating mechanism. Lastly, we provide an analysis of the policy implications of DDR’s in the context of climate change and nuclear build in the UK and the US