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The deal on discount rates

In a post a couple of months ago I looked at how the way we calculate the transport benefits of different projects ends up having a huge difference on its cost-benefit ratio. In particular, it was extremely interesting to note that if we had used the British discount rate and length of assessment when analysing the benefits of the City Rail Link project, it would have around five times the amount of benefit compared to the way such a project is analysed in New Zealand. The graph below summarises this issue: A recent paper by economic researchers NZIER provides a useful summary of discount rates and how New Zealand using a “discount rate” much higher than other countries affects the mix of projects we end up funding and not funding.

A discount rate lower (by a certain percentage), the amount of benefit from a project each year into the future, reflecting the fact that having money now is more valuable than having the same amount in the future. At 8% if a project delivered $1 million of benefits in its first year, then even if its benefits were the same in the second year, they would only be counted at $920,000,  $846,400 in the second year, $778,688 in the third year and so forth. This is explained further below, in the introduction to the research paper: To illustrate, you can see the difference in ‘level of benefit’ after a variety of years in the graph below – using two different discount rates: Much of the rest of the paper makes an argument that we should use a lower discount rate, to take more into account benefits of a project that will continue to exist well into the future. It also appears that there’s relatively little theoretical or practical logic behind the current rate used.

Obviously, if a lower discount rate is used and benefits are measured over a longer time-scale, then the cost-benefit ratios of our projects will go up. You can see this by comparing the (traditional transport benefits, earliest business cases) cost-benefit ratios of the City Rail Link and Puhoi-Wellsford projects:
The purpose of the comparison is not to compare the projects, but rather to highlight that lowering the discount rate has a fairly major impact on the BCR of a project. As we only have a certain amount of money available to spend on transport projects, a lower discount rate would – by necessity – raise the bar for the point at which projects were considered to make financial sense. We would have so many projects that look like they perform excellently, that we would have to make tougher decisions over which ones we proceeded with.

For this reason, I don’t really see having a lower discount rate as necessarily justifying a greater amount of expenditure on transport projects (although I’m pretty sure organisations such as the NZ Council for Infrastructure Development will do this). What will be of perhaps greater interest is how the mix of projects funded might change with a lower discount rate but a higher cut-off point. It seems logical that we might see projects with longer-lasting, but slower accumulating benefits, doing a bit better than those which give a quick, but short-lived, pay off. This would seem to be likely to benefit a project like the City Rail Link, perhaps a bit more than something like a motorway widening which will provide some benefit for a few years, before induced demand goes and eats up all that gain.

Auckland Council seems pretty determined to pursue, in partnership with the NZIER, further analysis on this issue and is wanting some more logic to sit behind whatever discount rate we decide to use. It will be interesting to see how this develops, as the government might be keen to try anything that will help improve the cost-benefit ratios of some of the RoNS projects – even if that’s done in a way which ends up benefitting the economic analysis of the City Rail Link even more.

5 comments to The deal on discount rates

  • Matt L

    It would probably be worth doing some sort of economic assessment of other long term infrastructure to see how much benefit they keep on providing. Take the Harbour bridge for example, under the current methodology we would have stopped getting benefit for it long ago but it wouldn’t surprise me if the benefit it now provides to the economy each year is worth more than the thing cost to build in inflation adjustment terms.

  • Which all goes to show how difficult it is to have a formula capable of comparing entirely different projects. And I take it that the social discount rate has nothing to do with the financial discount rate, which would attempt to compare the investment with a risk free rate of return.

    Then there are the arguments around what constitutes a benefit (reducing reliance on fossil fuels should surely count for something) and what constitutes a cost ( rail rolling stock / operational costs included in CBDRL but private vehicle depreciation excluded from roading projects) and the whole thing becomes a can of worms.

    In the end the BCR formula just reflects the values of the funding agency. Any new formula will be an outcome of political decision making as much as the decision to fund the project itself.

  • jm

    One of the key reasons why the UK discount rate is lower than NZ is that long term interest rates are typically significantly lower than NZ. NZ has to pay a risk premium compared to most of the rest of the developed world due to our perceived riskiness. As a result any project here has to provide a higher return relative to the UK hence the higher discount rate

  • Patrick R

    The idea the the CRL would be valueless in 40 years is absurd. They are still using Victorian tunnels under the Thames to run train through. They love rebuilding the motorway in Auckland, and I guess it would be nice to think we might have new trains by 2051 but going on recent history I wouldn’t count on it. The tunnels and track will still be the same.

  • C

    The link below has a bit of a two-way argument about the economics of the social discount rate. Michael Reddell is a Principal Advisor at the Reserve Bank of NZ.

    http://gropingtobethlehem.wordpress.com/2011/12/05/new-discount-rate-pub/

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