A cArbon cApture And storAge network for yorkshire And humber

9.4 DISCOUNT RATE
The decision to use an appropriate discount
rate to evaluate the cost of CCS is highly
important. There are a variety of discount
rates that could be used in this study.
Choosing the correct rate for a cost analysis
or CBA is important because society wishes,
in principle, to undertake a mix of public and
private investments that can maximize social
well-being. To undertake an investment, the
expected return on that investment must
cover all costs (investment, operation and
maintenance costs), including the rate of
interest. Under fairly restrictive assumptions,
one can argue that the investment will
continue until returns across alternatives
are the same and just balance the returns
required by savers. Under these conditions,
one can argue that a single interest rate and
a single rate of return on capital will prevail
throughout the economy. In reality, however,
there are a number of reasons that multiple
rates prevail. The choice facing the decision
maker is which of these many rates may
apply in a CBA.
There are several important points that need
to be considered when we make a decision
on the discount rate:
Higher interest rate verses lower
interest rates – although it is possible to
define the reasons that differentiate interest
rates, it does not mean that choosing a
rate for analysis is a simple task. On the
contrary, in the final analysis the choice of
a rate is fairly arbitrary. For this reason, it is
typically the case that individuals who are
in favour of larger government investments
to protect the environment can make
arguments for low rates, whereas those who
would prefer less government involvement
in the economy can make equally plausible
arguments for higher rates. It is clearly the
case that higher interest rates will lead
to fewer projects presenting positive net
present values than lower ones.
Carbon Capture and Storage Network 35
Unfortunately, the arguments used
to support both these positions are
complicated and fail to lead to a definitive
solution. Undertaking an additional public
project will be possible through displacing
private consumption, private investment
or some fraction of both. If one displaces
consumption by undertaking the public
investment, then the appropriate discount
rate is the consumer’s after tax time
preference, a relatively low rate of return.
If one displaces private investment the
investment displaced is at a higher, before
tax rate of return. Because the purpose of
CBA is to increase public well-being, it does
not want to use parameter variables that
lower the effective national rate of return
on investment or variables that displace
consumption by consumers inappropriately.
There are several approaches that have
been suggested to cope with this problem.
If one knew the proportion at which
the public investment displaced private
investment and private consumption
he/she could weigh the two and form an
average discount rate accordingly. Taking
the above into consideration, perhaps,
more appropriately one could apply a more
complicated model to take into account the
fact that the costs and benefits specifically
related to the displaced private consumption
and displaced private investment occur
at different points in time. In practice,
information needed for either approach
is generally unavailable. Thus, the debate
appears to return to personal preference for
public investment.
Inflation – It is difficult to model the range
of expectations, but, unless specifically
defined and modelled, there is implicit rate
within a total discount rate that reduces a
series of numbers over time to a present
value. We currently have a period of low
inflation that sees 1.5 to 3% inflation as
normal. For the purposes of time adjustment
to input costs, and including implicitly within
discount rates a single figure has been used
for this study.
Impact of taxes – Conflict in choosing a
rate generally arises over the role that taxes
play in determining interest rates. Because
of corporate income taxes and personal
income taxes, the rate of return on a private
investment is greater than the after tax
return. It is also true that the consumer
after tax rate of return time preference is
lower than the before tax rate of return. This
means that consumers make the decision
of how much to save based on the after tax
rate of return, while business investors make
the decision of how much to invest based
on before tax rates of return.
Climate change issues – Debates over
long-term environmental issues such as
global climate change (control of CO2
release) tend to focus on inter-generational
equity, rather than intra-generational
efficiency. The choice of an interest rate is
largely a pursuit to help the public sector
choose investments that will improve the
over-all level of national economic well-being
for a given set of consumers and investors.
Many investments take place over long timespans,
some of which are long enough to be
inter-generational. A decision to undertake
CO2 abatement to reduce the probability of
global warming is a decision to forgo the
increment of consumption or retirement
forever. Moreover, because most benefits
will occur long into the future, almost any
reasonable discount rate, even one reflecting
consumption time preference, rather than
private rate of return, will suggest that the
project is inefficient. For these reasons,
attention turns from efficiency concerns,
getting the right rate of private and public
rates of return, to equity concerns, taking
into account the rights of future generations.
Economists argue generally a social rate
of time preference is appropriate for intergenerational
discounting, which would be
composed of two components.