Best Practices in Energy Efficiency Program Screening - Synapse ...

5. Efficiency Screening Methodological Issues
5.1 Discount Rate
The choice of discount rate to use for calculating present values of costs and benefits
has significant implications for the cost-effectiveness of energy efficiency programs,
because program costs are typically incurred in the first years while program benefits are
enjoyed for the life of the energy efficiency measure. This section describes the
rationale for which discount rate should be applied when screening energy efficiency
programs, for each of the standard cost-effectiveness tests.
The Goal of Discounting
Financial analysis of investments in energy efficiency should account for the fact that an
energy efficiency initiative typically consists of an upfront investment in a structure or an
end-use piece of equipment, which is expected to provide returns, in the form of energy
savings, over a number of years. In order to compare costs and benefits that occur over
a number of years, the various cash flows (i.e., the initial investment and the annual
savings over the measure life) must be compared in a consistent way, usually as a
present value expressed in the dollars of a common reference year.
There is nothing special about energy efficiency in this regard; this challenge exists for
analyzing any long-lived investment. Economic and financial theory generally
acknowledge that a monetary benefit provided in a given year is more valuable than the
same monetary value delivered in a later year.
There are three commonly accepted reasons for this. One is inflation, which almost
always causes a dollar in a future year to have less purchasing power than a dollar in an
earlier year. The second reason is time preference; economic theory holds that people
simply value benefits in the present more than the same benefit in the future, at least
with respect to monetary benefits. The farther out in the future an expected benefit, the
more such a person would prefer a present benefit. The third reason is risk; future
monetary benefits from an investment are rarely guaranteed. The promise of a
monetary benefit in a future year has less value than an actual monetary benefit in the
current year due to the risk that the future benefit may not occur or may be less than
expected.
Accounting for Inflation
This part of the discounting is relatively straightforward, and requires a forecast of
inflation rates for the term of the project life. One option is to use an econometric
forecast, e.g., from an economic forecasting firm. Another common approach is to use
the historical long-term inflation rate or the average inflation rate for a period of recent
years. Either way, the assumed inflation rate can be used to turn each year’s costs and
savings into so-called “real dollars” or “constant dollars.” Typically, a project’s start year
or a base year for a utility’s other forecasting efforts would be chosen.
The choice of whether to use a “real” discount rate or a “nominal” discount rate depends
upon the inflation assumptions that are used in the annual costs and benefits of the
efficiency cost-effectiveness analysis. It is important that consistent assumptions are
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