Discounting, Disagreement, and the Option to Delay
43 Pages Posted: 27 Sep 2019 Last revised: 6 Jun 2021
Date Written: June 5, 2021
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: Suggested Citation