Discounting future flows is a critical step in Cost Benefit or Cost Effectiveness. Many institutions still use relatively high discount rates, which might not be applicable to projects where benefits-or costs- will happen way in the future in a world of rapidly declining cost of capital. Is it time to reconsider discount rates estimates for development projects, particularly in light of climate change and historically low interest rates?
If you work in climate change or education interventions, where benefits and costs materialize a long time from now, the choice of a discount rate is of critical importance. The background papers commissioned for the Stern Review concluded that this rate – which they base on the inter-temporal value of an extra unit of consumption (marginal rate of substitution) – is very low (on average 1.4%) and declines over time.
This approach is in sharp contrast with that typically taken by many governments and international agencies which base their discount rates on a uniform opportunity cost of capital and enforce its use across the board for all of investments. This typically yields discount rates in the 7-14% range which were first estimated in the 1960s.
But this tension on the estimation of a discount rate goes way back: from Arrow to Feldstein or from Sen to Harberger, the rate – reflecting which constraint was binding – ebbed and flowed, fluctuated and moved. But as economists do have more than two hands, in his classic 1982 article “Discount Rates” J. Stiglitz argued that the rate should vary from project to project, depending on which constraints are binding.
But this hot debate around the discount rate fizzled in the real world.
In 1955, Jan Tinbergen – in Design of Development – proposed a 10% discount rate, anchoring the debate. In their history of the World Bank, Mason and Asher write that “if Bank projects promise an internal rate of economic return of 10 percent—or even better of 12 percent—they are considered acceptable.”
To this day, the 10%-12% range is the standard used by the World Bank. Its 1998 “Handbook on Economic Analysis of Investment Operations which guides investment project evaluation: “The Bank traditionally has not calculated a discount rate but has used 10-12 percent as a notional figure for evaluating Bank–financed projects”. At the IDB this rate is typically 12%.
And this is a world where market interest rates fluctuate and change.
So it is refreshing that a recent article in the Journal of Benefit Cost Analysis retakes the topic of discounting.
Recently, a number of authors, including Burgess and Zerbe, have recommended the use of a real social discount rate (SDR) in the range of 6–8% in benefit-cost analysis (BCA) of public projects. They derive this rate based on the social opportunity cost of capital (SOC) method. In contrast, this article argues that the correct method is to discount future impacts based on the rate of social time preference (STP). Flows in or out of private investment should be multiplied by the shadow price of capital (SPC). Using this method and employing recent United States data, we obtain an estimate of the rate of STP of 3.5% and an SPC of 2.2. We also re-estimate the SDR using the SOC method and conclude that, even if analysts continue to use this method, they should use a considerably lower rate of about 5%.
Discuss: Should discount rates be a rationing mechanism – in a world flush with capital – or an inter-temporal equity distribution tool?