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used throughout. If the annual costs and benefits include the effects of inflation (i.e., are
in nominal dollars), then the discount rate should be in nominal terms. If the annual
costs and benefits are net of inflation (i.e., are in real dollars), then the discount rate
should be in real terms.
Accounting for the Time Value of Money
This is the time preference issue mentioned above. Suppose that an investor is offered
a guaranteed return for investing funds. What would that return have to be to attract
investments? Certainly it would have to cover the anticipated rate of inflation, but that will
usually not be sufficient. Most people would rather have something today than the same
thing in a year. Some extra return will be required.
This extra return is usually called a “risk free discount rate,” because it assumes there is
no risk associated with future benefits. (Risk will be discussed next.) In principle, such a
risk free discount rate measures how much the decision maker on a given project values
money this year versus next year. Note that the time value of money will be very
different for different decision makers. This point will also be discussed below.
Accounting for Risk
Adjusting for risk is the most difficult part of discounting. Again, the risk adjustment
depends on the perspective of the decision maker. Perhaps the simplest case is that
where the decision maker is a utility’s management. The source of an investor-owned
utility’s investment funds is a combination of bond investors and equity investors,
possibly including some preferred stockholders. Utility investments are typically
discounted at the weighted average cost of capital (WACC), i.e., the weighted average
yield of the company’s bonds and preferred stock along with its allowed return on equity.
When applying WACC for discounting, it is important to keep in mind that these values
come from markets that factor in all three issues: estimated inflation rates, time value of
money, and perceived riskiness of investing in the utility.
Application to the Cost Benefit Tests
While it is important to understand the economic theory underlying the application of
discount rates, it is also important to recognize that the choice of discount rate is
ultimately a policy call by the utility regulators. The choice of discount rates should be
informed by considering which party is being affected and what is the time value of
money for that party, but it should also be informed by considering how much weight the
regulators want to give to the future costs and benefits associated with energy efficiency
programs (especially benefits, because these occur well into the future).
Discount Rate for the Societal Cost Test
The Societal Test, as its name implies, should use a discount rate based on society’s
preferences. Compared to individuals and firms, society should have a broader tolerance
for receiving benefits in the future, and also be better able to access funds at a lower
borrowing cost. In this case, the discount rate should be relatively low.
Energy efficiency investments for special groups of customers, particularly low income
and at-risk populations could also be viewed with a societal discount rate for several
reasons. These customers are generally receiving some degree of support from society
at large, so the investment can appropriately be viewed in a societal context. It is society
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