Embedded Discounting and the Green Transition

Abstract

Net Present Value (NPV) calculations feature centrally in the economic appraisal of potential Green Transition investments, yet their high sensitivity to the choice of social discount rate (SDR) is an issue of material concern for project analysis. Considerable attention is routinely given to the SDR that explicitly features within the denominator of the NPV equation, yet discount rates are also less obviously embedded within various components of the NPV’s numerator. Taking a recently proposed geothermal district heating plant in the Danish city Aalborg as the basis for a case study, we question whether there is consistency in the choice of SDR across all elements of the economic and financial appraisal of Green Transition projects. While the NPV’s denominator reflected a real SDR of 3.5 percent, in keeping with Danish government guidance, emissions and electricity prices were based on carefully justified, yet different, costs of capital, as did the annuity rate applied in the financial analysis of the project. The use of corporate rates that are substantially higher than standard estimates of the SDR in some contexts potentially makes it more difficult for Green Transition projects to meet the legal requirement of being evaluated as socio-economically optimal.

Keywords: Social Discounting, Net Present Value, Socio-Economic Analysis, Geothermal, District Heating