Discount-Rate Uncertainty and Cost-Benefit Analysis: Should Long-Lived Projects be Treated Differently?
30 Pages Posted: 27 Sep 2019
Date Written: September 26, 2019
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: Suggested Citation