Unravelling the Impact of the Neutral Interest Rate in the Economics of Climate Change: An Empirical Analysis within the Case of the United States

Abstract

The aim of this study is to empirically explore how the neutral interest rate impact the economic assessment of future climate change damages through its interaction with discounting. This analysis is derived from an asset pricing framework, where empirical interest rate models that accommodates for shifts in the neutral interest rate, is utilised to quantitively estimate the dynamics of the neutral interest rate and its effects on the term structure of social discount rates (SDRs). Empirically, the study finds that the neutral interest rate has experienced a remarkably decline since the 1990s, which translates into a downward shift of the entire term structure of SDRs across all maturities. The study thereby argues that the neutral interest rate emerges as a fundamental anchor for market-based SDRs. Accordingly, as social discount rates are crucial for evaluating the costs of climate change, this imposes profound implications for climate policy. By taken into account the new, persistently lower baseline level of the neutral interest rate, the economic assessment of future climate change damages, measured in the terms of the social cost of carbon, significantly increases, advocating for a climate policy that emphasises stronger and more proactive carbon mitigation strategies.