3.1Social Rate of Return on Capital and Intergenerational Analyses
When analyzing policies and programs that result in GHG emission reductions, it is important to account for the difference between the social and private rate of return on any capital investment affected by the action. Society is not indifferent between a regulation that displaces consumption versus investment in equal amounts. Market distortions, in large part taxes on capital income, cause private returns on capital investments to be different from the social returns. In well-functioning capital markets, arbitrage opportunities will be dissipated, and the cost of investments will equal the present value of future private returns on those investments. Therefore, an individual forgoing consumption or investment of equal amounts as the result of a regulation will face an equal private burden. However, because the social rate of return on the investment is greater than the private rate of return, the overall social burden will be greater in the case where investment is displaced.
OMB’s Circular A-4 points out that “the analytically preferred method of handling temporal differences between benefits and costs is to adjust all the benefits and costs to reflect their value in equivalent units of consumption and to discount them at the rate consumers and savers would normally use in discounting future consumption benefits” (OMB 2003). The damage estimates developed for use in the SC-GHG are estimated in consumption-equivalent terms. An application of OMB Circular A-4’s guidance for regulatory analysis would then use the consumption discount rate to calculate the SC-GHG, while also developing a more complete estimate of social cost to account for the difference in private and social rates of return on capital for any investment displaced as a result of the regulation. This more complete estimate of social costs can be developed using either the shadow price of capital approach or by estimating costs in a general equilibrium framework, for example by using a computable general equilibrium model. In both cases, displaced investment would be converted into a flow of consumption equivalents.
In cases where the costs are not adjusted to be in consumption-equivalent terms, OMB’s Circular A-4 recommends that analysts provide a range of estimates for net benefits based on two approaches. The first approach is based on using the consumption rate of interest to discount all costs and benefits. This approach is consistent with the case where costs are primarily borne as reduced consumption. The second approach, the social opportunity cost of capital (SOC) approach, focuses on the case where the main effect of a regulation is to displace or alter the use of capital in the private sector (OMB 2003). When interpreting the SOC approach from the point of view of whether to invest in a single government project, it is asking whether the benefits from the project would at least match the returns from investing the same resources in the private sector. Interpreting the approach from the standpoint of a benefit-cost analysis of regulation, the approach focuses on adjusting estimates of benefits downward by discounting at a higher rate to offset additional social costs not reflected in the private value of displaced investment.
Harberger (1972) derived a more general version of the social opportunity cost of capital approach, recognizing that policies will most likely displace a mix of consumption and investment and therefore a blended discount rate would be needed to adjust the benefits to account for the omitted costs. In his partial equilibrium approach, the blended discount rate is a weighted average of the consumption interest rate and social rate of return on capital, where the weights are the share of a policy’s costs borne by consumption versus investment. This general result has been extended to the general equilibrium context by Sandmo and Drèze (1971) and Drèze (1974) and can be extended to account for changes in foreign direct investment (CEA 2017). This highlights that using the social rate of return for benefits and costs is at best creating a lower bound on the estimate of net benefits that would only be met in an extreme case
