On the role of discount rates when evaluating infrastructure projects, and what happens when a project’s benefits – environmental or those positively affecting a region’s natural capital – come about in the long term.
In an unprecedented act of generosity, and in order to promote reading the blog, the undersigned have collected all we had in our pockets to give it away to the one millionth reader of this post (we hope no one will think we are too optimistic about this blog’s success). We have gathered, in total, 3 dollars.
Another idea came to mind. We offer the lucky one, either of two options: a) to receive the prize money at once – he will receive 3 dollars on a single day – or, b) to receive it after 50 years.
We understand most of our readers would prefer receiving the money today. And of course, as time passes by, money tends to depreciate. But, by how much (or less)? Well, look, 3 dollars in 50 years’ time would be the equivalent of 0.02 dollars of today, assuming an interest rate of 10%. That means in 50 years we’d have to give the lucky one 235 dollars so as to compensate for the period of time passed. In the same manner we can express 3 dollars in future money; I can “bring back” money from the future and know how much it would be worth today by using a discount rate.
When we make an investment for an infrastructure project – such as developing roads, electrification or water for rural zones – we know there will be expenses, not only financial, but also environmental and social ones, and that we will receive a series of benefits. We are often faced with several project alternatives to solve a problem, all entailing their own costs and benefits in the long term. How do we compare all the different options? Easy, by “bringing” costs and benefits back from the future. This way we get a single figure for each project and may choose the option with the greater benefit for society.
The value used in order to reconcile flows of costs and benefits over time is crucial, and it clearly impacts project evaluation. This value is known as discount rate. The higher the rate, the less importance we confer to our future and thus to the resources of which future generations will make use. Therefore, a 10% discount rate implies all that happens in 50 years does not matter too much (1 dollar in 2066 equates 0.008 of today’s dollars), versus a 1% rate, where a 2066 dollar would equate 61 of today’s cents. Imagine, therefore, the importance of establishing one rate or another when evaluating different projects in which the environmental component is crucial.
If we were to establish high rates, what would happen with those projects whose benefits are generated in the very long term, such as some of the projects aimed at protecting the region’s natural capital? They wouldn’t have much weight in our decision making today. In short, we would prioritize projects with short-term benefits. This argument has led many countries to establish lower rates for projects with a strong environmental character or with great impact over the exploitation of their natural resources. For instance, countries such as Sweden or France have started to even consider, within their evaluation processes, a higher and more explicit concern for projects whose environmental implications have a very long-term effect.
There are multiple approaches, both methodological and philosophical around the value and calculation of the discount rate. Unfortunately, there is no consensus over them but instead ample variety around the rate used among countries and international credit institutions.
Thus, while the UK or the European Union settle rates at 5 and 3.5% respectively, some countries such as Colombia, Bolivia, Argentina, Uruguay, Costa Rica or India keep 12% rates, in addition to Peru (9%), Australia (7%) or the USA (7%).
It is quite possible for the rate’s observed variations to not only reflect the existence of different theoretical approaches, but also differences in the cost of social opportunities received from public funds, or regarding the degree to which inter-generational equity is considered (a central argument when debating about the environment and resource exploitation).
We, at the Department of Infrastructure and Environment of the IDB, wish to explore this matter and keep the debate going. Here is the link to our last report regarding social discount rates in project evaluation, where we offer some practical reflections for Latin America and the Caribbean. Proper project and public policy evaluation requires profound reflection over this topic, further than just accepting traditional criteria, for the light under which the future is assessed will condition decisions made today in the present.
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