Public infrastructure investment decisions are influenced by discount rates, which are used to discount future benefits and costs of projects to present value terms. Although discount rates may seem academic, they are underpinned by two simple intuitions. Firstly, discount rates incorporate the tendency for people to prefer things now rather than in the future. Secondly, societies are assumed to grow wealthier over time, so a dollar today, when people are poorer, may be perceived as more valuable than a dollar in the future when people are wealthier.
Despite record low interest rates in real terms, Australian governments have stuck with a consistent 7% central discount rate since at least 1989. Marion Terrill from the Grattan Institute argues it’s time for governments to adopt lower discount rates for public projects. This would mean projects with a high upfront capital cost and benefits which stretch well into the future are more likely to have a net present value (NPV) greater than zero (or benefit-cost ratio greater than one).
Adept Economics Director Gene Tunny caught up with Marion recently to discuss her 2018 Grattan Institute Report Unfreezing discount rates: transport infrastructure for tomorrow. To listen to the conversation, please use the player below. For show notes follow this link.
One of the fascinating points made by Marion related to how risk is incorporated into the discount rate. Marion notes discount rates should only incorporate systematic risk, and exclude idiosyncratic and downside risks. Idiosyncratic risk refers to the potential for a project to perform above or below expectations, whereas downside risk relates to the possibility of a project costing more or less than initial forecasts indicated. Systematic risk, then, is the expected response of a project’s returns to fluctuations in the broader economy.
This is not to say that idiosyncratic and downside risk should be disregarded. Take a bridge, for example. Idiosyncratic risk could arise from tolls accruing less revenue than expected. Similarly, downside risk could stem from the price of a certain input, say, metal, spiking due to production line issues. These risks are definitely real, but they are distinct from the impact of a subdued market on the bridge’s returns and should instead be considered in revenue and cost sensitivity analyses. Ultimately, incorporating all three risks into a single discount rate would incorrectly conflate largely uncorrelated factors.