Discount-Rate Disagreements and Cost-Benefit Analysis: Should Long-Lived Projects be Treated Differently?

35 Pages Posted: 27 Sep 2019 Last revised: 2 Nov 2020

See all articles by Graeme Guthrie

Graeme Guthrie

Victoria University of Wellington - School of Economics & Finance

Date Written: November 3, 2020

Abstract

Evaluating the benefits of investment projects related to climate change is complicated by the disagreements surrounding key model inputs, especially the discount rate. It is widely believed that disagreement about the discount rate requires relaxing the threshold needed to justify investment, and that a larger adjustment is appropriate for projects with longer lives. Relaxing the investment test like this is advocated because the present value of a future net benefit is a decreasing and convex function of the discount rate, and it becomes more convex the further we look into the future. By Jensen's inequality, introducing heterogeneity to the discount rate raises the expected value of this present value. However, this intuition also applies to the option to wait and reevaluate investment in the future. I find that incorporating investment-timing flexibility reduces---and in some situations reverses---the adjustment needed to allow for discount-rate heterogeneity. In particular, when discount rates are low, heterogeneity is high, and the project's lifetime is short, increases in discount-rate heterogeneity can lead to tougher (not easier) optimal investment tests. These results are obtained by modifying a standard investment-timing model to incorporate disagreement about the discount rate.

Keywords: social discount rate, cost-benefit analysis, discount-rate heterogeneity, climate change

JEL Classification: D61, G31, Q54, R42

Suggested Citation

Guthrie, Graeme, Discount-Rate Disagreements and Cost-Benefit Analysis: Should Long-Lived Projects be Treated Differently? (November 3, 2020). Available at SSRN: https://ssrn.com/abstract=3459994 or http://dx.doi.org/10.2139/ssrn.3459994

Graeme Guthrie (Contact Author)

Victoria University of Wellington - School of Economics & Finance ( email )

P.O. Box 600
Wellington 6140
New Zealand
64 4 463 5763 (Phone)

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