Discounting, Disagreement, and the Option to Delay

43 Pages Posted: 27 Sep 2019 Last revised: 6 Jun 2021

See all articles by Graeme Guthrie

Graeme Guthrie

Victoria University of Wellington - School of Economics & Finance

Date Written: June 5, 2021

Abstract

Evaluating the benefits of investment projects related to climate change is complicated by disagreements surrounding the discount rate. It is widely known that greater discount-rate heterogeneity increases the weighted-average present value of investing if the weighted-average discount rate is held constant, which therefore reduces the minimum internal rate of return needed to justify now-or-never investment. A larger adjustment is appropriate for projects with longer lives. I extend this analysis in two directions, first by giving the decision-maker the option to delay investment. Greater discount-rate heterogeneity also increases the weighted-average present value of the option to wait and reevaluate investment in the future. This weakens the relationship between discount-rate heterogeneity and the optimal investment threshold---and in some cases actually reverses it. When discount rates are low and the project's lifetime is short, increases in discount-rate heterogeneity can lead to tougher (not easier) optimal investment tests. The second extension examines the effect on these results of using different approaches to aggregate opinions about the discount rate, including the $\alpha$-maxmin, minimax-regret, and multi-utilitarian criteria.

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

JEL Classification: D61, G31, Q54, R42

Suggested Citation

Guthrie, Graeme, Discounting, Disagreement, and the Option to Delay (June 5, 2021). 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

HOME PAGE: http://sites.google.com/view/graemeguthrie

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