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

30 Pages Posted: 27 Sep 2019

See all articles by Graeme Guthrie

Graeme Guthrie

Victoria University of Wellington - School of Economics & Finance

Date Written: September 26, 2019

Abstract

Evaluating the benefits of investment projects related to climate change is complicated by the uncertainty surrounding key model inputs, especially the discount rate. There is widespread agreement that discount-rate uncertainty requires relaxing the threshold needed to justify investment (typically by using a relatively low discount rate), and that a larger adjustment is appropriate for projects with longer lives. Relaxing the investment test like this is advocated because overestimating the actual discount rate causes bigger valuation errors than underestimating the actual discount rate by the same amount. However, this intuition also applies to the option to wait and reevaluate investment in the future. We find that incorporating investment-timing flexibility reduces — and in some practically relevant situations reverses — the adjustment needed to allow for discount-rate uncertainty. In particular, when the discount rate is low and uncertainty is high, increases in discount-rate uncertainty can lead to tougher (not easier) investment tests. These results are obtained by modifying a standard investment-timing model to incorporate discount-rate uncertainty, including situations where the distribution of possible discount rates is unknown.

Keywords: climate change, cost-benefit analysis, discount-rate uncertainty, dynamic consistency

JEL Classification: G31, Q54, R42

Suggested Citation

Guthrie, Graeme, Discount-Rate Uncertainty and Cost-Benefit Analysis: Should Long-Lived Projects be Treated Differently? (September 26, 2019). 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)

Register to save articles to
your library

Register

Paper statistics

Downloads
12
Abstract Views
88
PlumX Metrics