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105 Discount Rates The value of the discount rate can have a large impact on a long-term BCA. Lower discount rates will favor capital-intensive scenarios relative to those that have less capital up front but perhaps more ongoing costs (such as operating and maintenance, or O&M costs). As an example, a 3 percent discount rate applied to a $100 cost in 100 years is equivalent to about $5 today. At an 8 percent discount rate, in 100 years $100 would be only about $0.05 in present-day terms. State governments generally do not have their own discount rates and defer to the federal government on the appropriate value. BCA preparers need to check to see whether the agency they are working with has a recommended discount rate to use. If none are available, the Office of Management and Budget (OMB) prepares the federal guidance. For U.S. government analyses, OMB recommends, for a project of average risk and using public funds, using a real pre-tax 7 percent rate and a 3.1 percent rate for sensitivity analysis. If private investment alone is used as a source of capital, OMB recommends about a 10 percent discount rate. If the project will have important intergenerational benefits or costs, agencies might also consider a further sensitivity analysis using a lower but positive discount rate in addition to calculating net benefits using discount rates of 3 and 7 percent. It is suggested to discount carbon emissions and savings using a 3 percent discount rate when using the median social cost of carbon. A 5 percent rate is suggested when using the low value of carbon (generated using a 5 percent discount rate), and 2.5 percent when using the high value. Federal Guidance on Discount Rates The type and value of discount rate used depends on the perspective of the organization conducting the analysis. Typically, for the type of projects discussed in this document, the organization undertaking the project is a state government, in which case a social discount rate is appropriate since the analysis is done from a broad social perspective. As a contrast, a private firm that completes a CBA will use a weighted average cost of capital that considers the cost of short-term debt, long-term borrowing, and equity weighted by the proportion of each used in the firmâs capital structure. The social discount rate can be thought of as measuring a 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 as being composed of a pure time preference and a premium for the uncertainty that benefits and costs will materialize in future. Alternatively, the social discount rate can be thought of as measuring the opportunity for reinvestment and compounding of benefits received or costs deferred. These three effects A P P E N D I X A Discount Rate Information
106 Incorporating the Costs and Benefits of Adaptation Measures in Preparation for Extreme Weather Events and Climate ChangeâGuidebook are called, in the economics literature, the rate of time preference, the risk adjustment of the discount rate, and the social opportunity cost of capital. For U.S. government analyses, OMB recommends using both the time preference rate (which tends to be lower and is estimated at 3 percent in real terms on a pre-tax basis) and the opportunity cost rate (which is higher and estimated at a real pre-tax 7 percent rate, reflecting the forgone rate of return). A Possible Consensus-Based Exception to the Rule: Carbon Emissions Discounting Practitioners of CBA for projects that include changes in CO2 currently have some conflicting directions. The federal administration currently mandates 7 percent (with 3 percent sensitivity) for all costs and benefits including carbon emissions and savings, whereas scientists and economists recommend a mid-point estimate of 3 percent (with a low of 2.5 percent and a high of 5 percent). Adding to the confusion is that some states are relying on carbon estimates that use the lower discount rate: âPolicymakers and regulators in several states, including New York, Minnesota, Illinois and Colorado, are using the social cost of carbon to measure and reduce CO2 impacts from their power gridsâ (Fairley, 2017). In light of the conflicting federal policy and consensus recommendations, the research team suggests â¢ When applying to national analyses and grants, such as discretionary grant funding through the BUILD program, use a 7 percent discount rate for carbon and non-carbon costs and benefits (with a 3 percent rate as a sensitivity analysis) unless, of course, grant guidance states otherwise. â¢ For state analyses, follow recent (i.e., after March 2017) precedents. â¢ If CBA practitioners wish to follow the National Academies guidelines, which reflect the scientific and economic consensus, a 3 percent (and perhaps declining) discount rate for carbon (with 2.5 and 5 percent being high and low values) can be used. There is no guid- ance yet available on combining carbon and non-carbon, so the safest approach may be to present all discount rate combinations (2.5, 3, and 5 percent for carbon and 7 and 3 percent for non-carbon) and showing a range of net benefits discounted using these combinations. Before 2018, the U.S. DOT was explicit in its TIGER Cost-Benefit Guidance that all benefits and costs (that exclude carbon dioxide emissions) should be discounted at 7 percent (and 3 percent as a sensitivity analysis), and the net value of carbon dioxide emissions at the 3 percent discount rate. Regarding the lower discount rate, scientists and economists widely endorse these methodological choices. âThe National Academies of Sciences and the U.S. Council of Economic Advisers strongly support a 3 percent or lower discount rate for intergenerational effects. A 7 percent rate based on private capital returns is considered inappropriate because the risk profiles of climate effects differ from private investmentsâ (Revesz et al., 2017). Recommendations in the report Valuing Climate Damages: Updating Estimation of the Social Cost of Carbon Dioxide are given related to the discounting of project costs and benefits that include the social cost of carbon (National Academies of Sciences, Engineering, and Medi- cine, 2017). The report points out two issues related to discounting: that the rate for carbon is expected to be lower for carbon than for non-carbon net benefits because of intergenerational costs and benefits associated with climate change and that the discount rate is related to growth in the economy and hence environmental damages. Its recommendations call for the Interagency Working Group on Social Cost of Greenhouse Gases (IWG) to provide clarity on these issues. In March 2017, however, President Trump issued an executive order disbanding the IWG and
Discount Rate Information 107 rescinding its guidance documents in favor of the OMB guidance that uses a higher (7 percent) discount rate than that from the IWG (3 percent) (Presidential Executive Order, 2017). If practitioners wish to follow the consensus view, the reason carbon costs and benefits are suggested to be discounted at a lower 3 percent discount rate than other costs and benefits (discounted at 7 percent) is that in calculating the Social Cost of Carbon (SCC), the stream of future damages is discounted to its present value in the year when the additional unit of emissions was released, using a discount rate that reflects societyâs marginal rate of substitution between consumption in different time periods. It does not reflect the social opportunity cost of capital. There is a range of SCC values in the federal guidance. When using the lower (or higher) carbon numbers, earlier federal guidance said to use the 2.5 percent (or 5 percent) discount rate: While the SCC estimate grows over time, the future monetized value of emissions reductions in each year (the SCC in year t multiplied by the change in emissions in year t) must be discounted to the present to determine its total net present value for use in regulatory analysis. Damages from future emissions should be discounted at the same rate as that used to calculate the SCC estimates themselves to ensure internal consistencyâi.e., future damages from climate change, whether they result from emissions today or emissions in a later year, should be discounted using the same rate. For example, climate damages in the year 2020 that are calculated using a SCC based on a 5 percent discount rate also should be discounted back to the analysis year using a 5 percent discount rate. (U.S. EPA, 2016a) This is the rationale for the previous suggestion to discount carbon emissions and savings by 5 percent when using the low value (generated using a 5 percent discount rate) and, when using the high (2.5 percent) value, to discount savings by 2.5 percent. The federal government recommends a 7 percent discount rate for carbon and non-carbon (with another calculation using a 3 percent sensitivity). The National Academies asks that the (disbanded) IWG provide clarity and guidance on a 3 percent (and perhaps declining) discount rate for carbon (with 2.5 and 5 percent being high and low values). There is no guidance on combining carbon and non-carbon, so the safest approach may be to present all discount rate combinations (2.5, 3, and 5 percent for carbon and 7 and 3 percent for non-carbon) and show a range of net benefits discounted using these combinations. An example is shown for 10 years of (randomly generated) (real, or after inflation) carbon net benefits (benefits minus costs) between $80 and $150 and (random) real non-carbon net benefits between $800 and $2,500. The table shows the net present values (NPVs) using various discount rates. Discount Rate NPV Carbon Net Benefits NPV Non- Carbon Net Benefits 2.5% $1,061 A 3.0% $1,032 B $12,881 E 5.0% $927 C 7.0% $836 D $10,542 F Minimum $836 G $10,542 H Maximum $1,061 I $12,881 J Nat. Academies NPV Range $11,469 C+F $13,942 A+E Overall (National Academies and Fed. Gov't) NPV Range $11,378 D+F $13,942 A+E Year Carbon net benefits ($) Non- carbon net benefits ($) 1 89 1,851 2 122 1,651 3 111 809 4 82 1,179 5 126 1,194 6 122 1,863 7 132 1,356 8 141 1,881 9 150 1,397 10 150 2,004
108 Incorporating the Costs and Benefits of Adaptation Measures in Preparation for Extreme Weather Events and Climate ChangeâGuidebook Providing a range from $11,378 to $13,942 would encompass â¢ The White House (and U.S. DOT) recommended NPV using a 7 percent discount rate value. â The low value is equal to the bolded values of the carbon NPV of (D) $836 plus a non- carbon NPV of (F) $10,542. â¢ The National Academiesâ highest NPV value, using 2.5 percent for carbon and 3 percent for non-carbon. â The high value is equal to the italicized values of (A) $1,061 carbon plus the non-carbon NPV of (E) $12,881. This approach covers all the bases by providing a range of values that incorporates current federal policy and scientific and economics consensus. Social Discount Rate The social opportunity cost of capital is the expected rate of return forgone from other potential investments. âIf government investment comes at the expense of private investment, the cost to the economy is measured by the social returns that would have been generated by that investment. This has been variously labeled the investment rate of interest, the producer rate of interest, the marginal rate of return to investment or capital, the marginal efficiency or product of capital, or the social opportunity cost of capitalâ (Harrison, 2010). OMB estimates that social opportunity cost of capital, as measured by the real, pre-tax rate of return on all sources of private capital in the United States, is approximately 7 percent (OMB, 2016). This rate is the social opportunity cost of capital, the cost of diverting funds to government projects that could be productively used elsewhere. âIt is the appropriate discount rate whenever the main effect of a regulation is to displace or alter the use of capital in the private sectorâ (OMB, 2003). OMB also notes that if a project is expected to displace corporate business investment, sensitivity at a rate higher than 7 percent should also be analyzed, reflecting the forgone rate of return. If business investment alone is used as a source of capital, OMB puts this figure at about 10 percent. In addition, the recommended 7 percent social opportunity cost of capital only reflects the average degree of risk of displaced projects. It does not include any premium of adjustment for the uncertainty of risk for the scenarios considered. Rate of Time Preference We saw why individuals might have a pure time rate of preference: People are impatient; they donât live forever; possessions can be lost, destroyed, or stolen, and opportunities disappear. A reasonable indi- vidual may discount the future for any one of these reasonsâwhy should I pay money now to reduce damages from global warming that will only occur after I am dead?âbut the same logic does not apply to society: Relative to the individuals of which they are composed, societies are immortal and uncertainties are averaged out. For this reason, there is, in fact, fairly wide consensus within the economics profession that social discount rates should indeed be lower than individual discount rates. The social discount rate is a rate of conversion of future value to present value that reflects societyâs collective ethical judgment, as opposed to an individualistic judgment, such as the market rate of interest. (Daly and Farley, 2004) When regulation primarily and directly affects private consumption (e.g., through higher consumer prices for goods and services), a lower discount rate is appropriate. The alternative most often used is sometimes called the âsocial rate of time preference.â This simply means the rate at which âsocietyâ dis- counts future consumption flows to their present value. If we take the rate that the average saver uses to discount future consumption as our measure of the social rate of time preference, then the real rate of return on long-term government debt may provide a fair approximation. Over the last thirty years, this rate has averaged around 3 percent in real terms on a pre-tax basis. For example, the yield on 10-year Treasury notes has averaged 8.1 percent since 1973 while the average annual rate of change in the CPI over this period has been 5.0 percent, implying a real 10-year rate of 3.1 percent. (OMB, 2003)
Discount Rate Information 109 So, OMB estimates the time preference rate at 3.1 percent and the social opportunity cost of capital to be 7 percent. U.S. government guidelines suggest that both be used, with a base rate of 7 percent and a sensitivity of 3.1 percent. Social Discount Rate and Sustainability The social discount rate is a contentious issue. For sustainability analysis in particular, there is much dissent because of the long time horizons involved. Some sustainability advocates have argued for a zero or low discount rate so that long-lived environmental costs are dealt with sooner rather than deferred for future generations. Alternatively, the benefits of distantly realized environmental improvements are not reduced in decisions made today. A zero discount rate gives equal weight to present and future generations. Analysts disagree whether long time horizon problems merit special consideration. Some economists and policy analysts argue that benefits accruing to future generations should not be discounted at all. Others believe that intergenerational concerns can often be addressed by using a social rate of time preferenceâ the rate of time preference modified to reflect intergenerational equity considerations. . . . The draft EPA white paper on discounting suggests that when faced with a situation involving intergenerational concerns, 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 prefer- ence (effectively discounting all expected future benefits in the same way). (U.S. EPA, 1999) One argument for a low rate when considering sustainability issues is that the opportunity cost of capital depends on growth. Sustainability advocates point out, âthe economy as a whole cannot grow indefinitely, in which case a social discount rate into the indefinite future may be inappropriateâ (Daly and Farley, 2004). The profitability of investments used in the opportunity cost calculation is ââprofitableâ because we ignore many of the costs of production. We know that all human productive activities use up natural resources and return waste to the environment, and these costs of production are often ignoredâ (Daly and Farley, 2004). Applying a zero discount rate also presumes that the estimates of very long-term consequences are as reliable as estimates of consequences that are expected in the short term. It gives equal weight to an estimated consequence in hundreds of years as it does to one that will occur today, even though there is much less reason to believe that the future consequence will unfurl as currently predicted . . . There is little doubt that people value sustainability and are concerned about the state of the environment and the quality of life that future generations will inherit. However, there are better ways to take this into account in benefit-cost analysis than by imposing a zero discount rate in the evaluation of forecast long-term consequences. (Shaffer, 2010) OMB recommends that if a project âwill have important intergenerational benefits or costs you might consider a further sensitivity analysis using a lower but positive discount rate in addition to calculating net benefits using discount rates of 3 and 7 percentâ (OMB, 2003). The Federal Emergency Management Agency (FEMA) has chosen to follow OMBâs discount rate guidance. FEMA recommends that âin order to compare the future benefits to the current cost of the proposed mitigation project, a discount rate is applied over the life of the project to calculate the net present value of the expected annual benefits. For FEMA- funded mitigation projects, the discount rate is set by the Office of Management and Budgetâ (FEMA, 2013a). U.S. DOT Transportation Investment Generating Economic Recovery (TIGER) Discretionary Grants guidance recommended the same (7 percent or 3 percent) discount rate, but also a 3 percent discount for monetized CO2 emissions benefits and costs: [C]arbon emissions are valued differently from other benefits and costs from the perspective of discount rate. Applicants should continue to calculate discounted present values for all benefits and costs
110 Incorporating the Costs and Benefits of Adaptation Measures in Preparation for Extreme Weather Events and Climate ChangeâGuidebook (that exclude carbon dioxide emissions) at 7% and 3%, as recommended by OMB Circular A-94. To these non-carbon NPV benefits, the Applicant should then add the corresponding net value of carbon dioxide emissions, as calculated from the 3% SCC value. (U.S. DOT, 2016) However, the TIGER program was discontinued in 2017 and replaced by the BUILD program in 2018. The federal grant guidance issued in 2018 recommends using the 7 percent discount rate for all analyses. CBAs completed for grants need to follow the grant guidance. Analyses completed for other funding sources need to follow guidance issued for the funding source. If no discount rate guidance for CO2 emissions is provided, analysts can consider conducting sensitivity analyses using both the 3 percent and 7 percent values. International Comparisons Social discount rate suggestions vary considerably. One review across countries identifies rate suggestions ranging from 1 percent to 15 percent (Harrison, 2010). In small open economies, such as Canada, calculations of a weighted average social opportunity cost of capital depend on how much private investment is displaced and the ability to attract foreign investment. The lower limit on the estimate should be the cost of foreign borrowing. Federal government estimates of real pre-tax rates in Canada have fallen from 10 percent to 8 percent, but have always been higher than the U.S. 7 percent rate. In a contrary view, for the province of Ontario, Spiro (2010) estimates the social discount to be a real 5 percent rate of return. On the SCC for cost-benefit analyses of regulatory proposals, in March 2016 Canada adopted the U.S. numbers for the SCC but converted the numbers to Canadian dollars and used the 3 percent discount rate only (rather than the 2.5 percent and 5 percent discount rates). Canadaâs interdepartmental working group recommended the adoption of the U.S. values in 2011, with a few minor adjustments. Instead of four different values, the group recommended two estimates using the same discount rate. (Environment and Climate Change Canada, 2016) The Canadian numbers have an average and a 95th percentile both using the 3 percent social discount rate recommended by Canadaâs Treasury Board Secretariat Analysis Guide. The Treasury Board recommends that a real rate of 8 percent be used as the discount rate in Canada, whereas the social time preference rate, which is based on the rate at which individuals discount future consumption and projected growth rate in consumption and is a component of this discount rate, has been estimated to be around 3 percent. For the Canadian calculation of the 95th percentile estimates, the results of the one of the three models used in the U.S. estimates are not included. It was felt that one model (the FUND model) did not incorporate the low-probability, high-cost events. For reference, the FUND model gives up to a $65 value at the 95th percentile and 3 percent discount rate, whereas the PAGE model estimates up to $90 and the DICE model up to $369. By excluding the model with the lower estimates, the 95th percentile is higher in Canada than in the United States. Social Discount Rate Conclusion If organizations have internal recommended discount rates for evaluating projects, it is logical to use them in CBAs. Consideration may be given to the source of funds, risk of the project, and any intergenerational aspects of the project to see whether the value is appropriate. In the absence of organizational guidance or recommendations, organizations can follow the U.S. federal government guidance and use a 7 percent real discount rate. Because of the large range of values and the potentially large impacts on the net present value of net benefits, practitioners might input the social discount rate as probability distribution in
Discount Rate Information 111 the analysis. If this approach is taken, the results reflect the difference between the time prefer- ence approach, the social opportunity cost of capital approach, and the project and cost/benefit risk-adjusted discount rate approach. Using the discount rate as an input has the added benefit that the decision can be based on one set of results for the scenarios rather than results for dif- ferent discount rates. The alternative approach of doing a sensitivity analysis means that decision makers have to choose between different results based on competing economic methodologies, of which they may have little understanding. One possible approach to using a range of discount rates would be to bound the real social discount rate at 0 percent as an extreme position (with little probability of occurring in the Monte Carlo analysis). Because the focus is on long-lived infrastructure projects that may involve intergenerational effects, based on the OMB recommendation one could use the rate of time preference of 3.1 percent as the medium value. The social opportunity cost of capital estimate of 7 percent could be used for the high end of the range. If private funds are used, practitioners could use a private discount rate or weighted average cost of capital instead of the social cost of capital. This may be appropriate if the project proponent is a private entity. If no internal weighted average cost of capital is available, OMB recommends a 10 percent rate.