Discount rates and the value of the future

Would you rather have a dollar now or two dollars in ten years’ time? A single tree now or a forest in fifty years?
The answers to questions like these have a surprisingly big impact on what investment and spending we prioritise as a society. 

A fairly core concept in economics, particularly as it relates to transport investment decisions, is the discount rate. Simply put, the discount rate reflects the intuitive idea that a sum of money (or other benefit) in the future is generally worth less to us than the same amount today – future benefits and costs are discounted compared to their current value. The higher the discount rate, the higher the future discount. If the discounted costs of a project exceed its discounted benefits, it is unlikely to be funded or implemented (with some exceptions). 

New Zealand Treasury recently made a big (in economics circles) splash by recommending significant changes to the discount rates used when evaluating government investments.  

How have discount rates been set previously? 

Treasury has historically used a 5% discount rate to analyse future social benefits and costs, based on other financial investment options with a comparable risk profile. A similar procedure is currently used by NZTA Waka Kotahi to arrive at their default discount rate of 4%. 

A paper written for Treasury to discuss discount rate choice highlights that Treasury’s historical practices mean that benefits worth $100 today would be discounted to less than $1 if they occur in a century’s time. When making decisions which have long-term impacts, such as on climate change, biodiversity or urban form, it is easy to see how existing practice fails to value many impacts on future generations. 

Additionally, there are other issues with previous approaches to discounting:  

• Although we can estimate the monetary value of “non-market” benefits – such as safety, amenity and health – by definition these benefits can’t be traded for cash, and delaying these benefits is not the same as delaying a cash payment. 

• The “risk profile” of non-market benefits is not directly comparable to the risk of a financial investment.

• While we might choose to discount our own future benefits, from an ethical standpoint it doesn’t necessarily follow that we should discount benefits for future generations relative to our own. 

What is Treasury recommending now? 

To address these issues, the latest Treasury guidance recommends that different discounting practices are followed depending on whether a project or policy has mainly commercial (market) or non-commercial (non-market) costs and benefits: 

SRTP (Social Rate of Time Preference) – based on the preference for consumption now rather than in the future, 
SOC (Social Opportunity Cost) – based on the opportunity cost compared to an alternative investment with market returns. 

For non-commercial projects, this represents a huge decrease in the discount rate, and a subsequent boost in the emphasis on long-term benefits and costs. For example, under this new approach a non-market benefit worth $100 today is now worth $20 a century into the future
– a 20x increase in the value placed on these benefits compared to previous discounting practices.  

The net effect will likely be higher prioritisation of projects which deliver long-term non-commercial benefits. Projects with primarily commercial returns will also face higher barriers to investment, as the discount rate for these increases from 5% to 8%. In all cases, sensitivity testing with high (8%) or low (2%) discount rates is also required. 

Why does this matter? 

While NZTA has not yet adopted this new discounting approach, these principles are clearly applicable to the economic evaluation of transport projects. Many of the benefits that transport investments produce are non-commercial – for example, health benefits due to increased walking and cycling, reductions in death or serious injury, or the environmental impacts of reduced emissions. 

If these discounting changes find their way into NZTA procedures, it will represent a significant re-shaping of investment decision-making.
The result will be a stronger emphasis on long-term planning and investment which delivers value to society well into the future. 

Get in touch with Abley's Modelling & Economics team to learn more or to discuss how we can help you with your economic analysis and research.