Posted 03/10/2018 by Dr. Jonathon Deans
In the Building Up and Moving Out report tabled in Parliament in September 2018, the House of Representatives Standing Committee on Infrastructure, Transport and Cities recommended the adoption of a 4% discount rate for the appraisal of Commonwealth infrastructure projects. This FlagPost explains the use of discount rates and provides context for the Committee’s recommendation.
The use of discount rates
Government agencies like Infrastructure Australia routinely use cost-benefit analysis (CBA) as a decision-making tool. In a CBA, the impacts of a decision or investment are quantified on a standardised basis. This allows them to be compared and to determine whether the project creates net benefits for the community. The Department of the Prime Minister and Cabinet (PM&C) has published a guidance note which states that the goal of CBAs is to provide decision-makers with as much information as is relevant to encourage better decision-making.
In infrastructure CBAs, most of the costs are incurred soon after the project is approved, while the benefits are realised over decades. As benefits enjoyed in the distant future are worth less than benefits enjoyed in the present, future values need to be discounted back to a present value. Generally this is done with a consistent annual rate, known as the discount rate, which compounds similar to interest on a savings account (except in reverse).
The choice of discount rate matters. A large discount rate will reduce the value of future benefits significantly faster than a lower rate. For example, $100 paid in ten years with a 4% discount rate has a present value of $67.56. With a 10% discount rate, the present value is $38.55. If this future benefit is compared with a cost of $50, the project can only proceed if it is evaluated with the lower discount rate.
Setting the discount rate too high means that some projects that benefit the community will not be approved. The opposite is also true—setting the discount rate too low means that some projects will be approved, even though they do not create genuine benefits. Choosing an appropriate discount rate is important in ensuring that CBAs properly inform decision-makers. There is, however, no objectively correct discount rate.
Australian Government policy
In 2010, the Productivity Commission published Valuing the Future, a research paper on discount rates. The paper explored the various approaches and considerations for determining a government-wide discount rate and ultimately recommended the adoption of an 8% rate. This was based on the long-term average of the marginal rate of return on private capital investments, less tax distortions and foreign borrowing. In other words, the Australian Government should only fund projects where it can be confident that it can generate a return equivalent to that of private investments (as that is the alternative use of scarce capital).
The research paper also recommended that proposals include sensitivity analysis using other discount rates (3% and 10%). This analysis provides decision-makers with information about the importance of the discount rate in the CBA. The 3% rate was chosen to represent the risk-free rate of return (essentially the rate at which the Australian Government can borrow) and the 10% rate was chosen to reflect the marginal productivity of capital in the previous decade (essentially the return needed for a high-risk investment).
By at least 2014 (see p. 39), the Office of Best Practice Regulation (OBPR) in PM&C was recommending the use of a 7% discount rate with sensitivity analysis using discount rates of 3% and 10% (while reference is made to the Productivity Commission research paper, it is not clear why OBPR adopted this rate rather than the recommended 8%). This has become the standard approach and is required for Infrastructure Australia appraisals, the Assessment Framework for which notes that the rate ‘aligns with the majority of current national, state and territory guidelines’ (see p. 104).
Recent developments
The appropriateness of the 7% rate has been subject to debate in 2018.
In March 2018, the Grattan Institute published Unfreezing Discount Rates, a research paper which argued the risk-free interest rate had fallen to 0.8% and this should be reflected in lower discount rates. The report suggested discount rates of 3.5% for low-risk infrastructure projects (such as urban roads and some urban public transport projects) and 5% for those bearing greater risks (such as ferry and freight rail projects).
In May 2018, Applied Economics published Choosing the Social Discount Rate for Australia, a research paper which argued that discount rates should be determined by the opportunity cost of capital rather than the cost of funds. This view is shared by the Reserve Bank of Australia (see footnote 9). The Applied Economics paper concluded that the appropriate rate for Australia was 6.5%.
In June 2018, the New South Wales Standing Committee on State Development published Regional Development and a Global Sydney, which recommended a review of the 7% discount rate used by the state government.
The recent Building Up and Moving Out report recommended that the Australian Government adopt a 4% discount rate. To support this recommendation, it cited evidence that the current 7% rate was too high given the historically low level of interest rates, and that the current rate was an obstacle to investing in specific projects. The report also suggested that Infrastructure Australia could adopt the 4% rate in its analyses.
As yet, there has been little public reaction to the recommendation, although one media report quoted the acting chief executive of Infrastructure Australia, Anna Chau, as saying that lowering the discount rate would be a form of ‘intergenerational theft’ and that it be would ‘like lowering the passing grade from 50 per cent to 25 per cent’.