Positive, Zero or Declining

by | May 11, 2015 | Economics

Sustainability means meeting the needs of the present without compromising the ability of future generations to meet their own needs. Infrastructure decisions can involve future generations and so the question this post addresses is should we weight their needs the same as ours? Doing so implies using a discount rate of zero. There is an ongoing debate amongst economists over the best way to value costs and benefits that occur in the future. The debate is centered on the discount rate which is used to calculate the Sustainable Net Present Value (S-NPV) of a project, should it be constant and positive or zero, or should it be declining?

The social discount rate can be bounded by two discount rates: the social opportunity cost of capital and the rate of time preference.The social opportunity cost of capital is the expected rate of return from other potential investments which the Office of Management and Budget (OMB) in the U.S. measures as the real, pre-tax rate of return on all sources of private capital in the United States at 7%[1]. The rate of time preference is the time preference for the present over the future and an opportunity cost that using resources today means that they are not invested for use later. The time preference can also be thought of being composed of a pure time preference and a premium for the uncertainty that benefits and costs in the future will materialize. The rate of time preference is often given by a market rate of interest.The OMB estimates the rate of time preference to be an inflation adjusted 3.1%[2] which is calculated from the average yield on 10-year treasury bonds adjusted for average annual inflation since 1973.

The Green Book

The U.K uses the lower social rate of time preference. The U.S. and Canada use the higher social opportunity cost of capital. The U.S. also suggests using the lower social rate of time preference as a sensitivity.

An alternative to the constant positive discount rates discussed above is a zero discount rate. A discount rate of zero gives equal weight to present and future generations. This means that; long-lived environmental costs are not discounted and therefore are given more weight and therefore should be dealt with sooner rather than later to the benefit of future generations. Economists debate the merits of a zero versus positive discount rate. The EPA outlines that “the analyst should acknowledge that both sides of this debate have merit and calculate the present value of future benefit streams using both a zero discount rate (not discounting at all) and the rate of time preference (effectively discounting all expected future benefits in the same way)…”[3].

Another alternative exists in which the rate of time preference declines into the future to reflect the uncertainty of discount rates. Uncertainty with respect to discount rates arises due to the dependence on growth, sustainability advocates point out “the economy as a whole cannot grow indefinitely, in which case a social discount rate into the indefinite future may be inappropriate.”[4] Both the U.K. and France have adopted declining rates of time preference in which future costs and benefits are given more weight than a standard constant rate of time preference, but do not give as much weight as a zero discount rate. Above we mentioned that the U.K. uses the lower time preference cost. In addition the HM Treasury (U.K.) guideline for appraisal and evaluation states that when the appraisal of a proposal depends on discounting effects in the very long term, lower discount rates beyond 30 years should be used. In accordance with this the declining long term discount rate schedule is as follows[5]:

The larger picture in all this is that the discount rate that we choose when valuing long-lived sustainability and resiliency projects matters, especially with regards to environmental costs and benefits. Many famous names in economics advocate this but admit that the estimation is challenging (Kenneth J. Arrow , Maureen L. Cropper, Christian Gollier, Ben Groom, Geoffrey M. Heal, Richard G. Newell, William D. Nordhaus, Robert S. Pindyck , William A. Pizer, Paul R. Portney, Thomas Sterner, Richard S. J. Tol , and Martin L. Weitzman)[6].

The default in AutoCASE are the guidelines set forth by the OMB and the Treasury Board of Canada (i.e we use the higher social opportunity cost of capital rather the lower (and perhaps declining) time preference discount rate. AutoCASE allows discount rates to be overridden by the user if they prefer a different discount rate, and we are open to adding a declining discount rate if users see value in this option.

[1] https://www.whitehouse.gov/omb/circulars_a004_a-4

[2] Ibid.

[3] U.S. Environmental Protection Agency Office of Air Quality Planning and Standards Innovative Strategies and Economics Group “OAQPS Economic Analysis Resource Document” http://www.epa.gov/ttnecas1/econdata/Rmanual2/8.3.html

[4] Ecological Economics: Principles and Applications , Herman Daly and Joshua Farley, Washington: Island Press, 2004, pp.273-274.

[5] HM Treasury “The Green Book: appraisal and evaluation in central government” https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/220541/green_book_complete.pdf

[6]“How Should Benefits and Costs be http://www.rff.org/RFF/Documents/RFF-DP-12-53.pdf

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