Guide to COST-BENEFIT ANALYSIS of investment projects - Ramiri

This Guide supports a unique reference FDR value based on the assumption that the funds are drawn from the EUmedian taxpayer. This means that even if the project is region- or beneficiary-specific, the relevant opportunity costof capital should be based on a European portfolio. Moreover, the integration of financial markets should lead to aunique value as long as convergence of both inflation and interest rates across EU countries is expected in the longterm.This may not, however, be true of IPA countries and, under specific circumstances, of some EU MemberStates.It should be noted that as long as the FDR is taken as a real discount rate, the analysis should be carried out atconstant prices. If current prices are used throughout the financial analysis, a nominal discount rate (which includesinflation) must be employed.The social discount rateThe discount rate in the economic analysis of investment projects - the social discount rate (SDR) – should reflectthe social view on how future benefits and costs are to be valued against present ones. It may differ from thefinancial rate of return because of market failures in financial markets.The main theoretical approaches are the following:- a traditional view proposes that marginal public investment should have the same return as the private one, aspublic projects can displace private projects;- another approach is to derive the social discount rate from the predicted long-term growth in the economy, asfurther explained below in the social time preference approach;- a third, more recent approach, and one that is especially relevant in the appraisal of very long-term projects, isbased on the application of variable rates over time. This approach involves decreasing marginal discount ratesover time and is designed to give more weight to project impacts on future generations. These decreasing rateshelp mitigate the so-called ‘exponential effect’ from the structure of discount factors, which almost cancels moredistant economic flows when discounted in a standard way.In practice a shortcut solution is to consider a standard cut-off benchmark rate. The aim here is to set a required rateof return that broadly reflects the social planner’s objectives.Still, consensus is growing around the social time preference rate (STPR) approach. This approach is based on thelong term rate of growth in the economy and considers the preference for benefits over time, taking into account theexpectation of increased income, or consumption, or public expenditure. An approximate and generally used formulafor estimating the social discount rate from the growth rate can be expressed as follows:r = eg + pwhere r is the real social discount rate of public funds expressed in an appropriate currency (e.g. Euro); g is thegrowth rate of public expenditure; e is the elasticity of marginal social welfare with respect to public expenditure, andp is a rate of pure time preference.On the basis of social time preference, France set a 4% real discount rate in 2005 (formerly fixed at 8%); in 2004Germany reduced its social discount rate from 4% to 3%. The HM Treasury Green Book of 2003 was actually theprecursor of these reductions: the real discount rate in the UK was reduced from 6% to 3.5% 108 .The EC, DG Regio, has suggested a 5.5% SDR for the Cohesion countries and 3.5% for the others (EC WorkingDocument 4) 109. Every Member State should assess its country-specific social discount rate. In any case, there may begood arguments in favour of using these two benchmark values for broad macro-areas in terms of their potential foreconomic growth (see below).For our practical purposes, it may be useful to reinterpret the STRP formula in terms of consumption. Let ussuppose g is the growth rate of consumption, e is the elasticity of marginal utility with respect to consumption, and pis the inter-temporal preference rate.108The application of declining discount rates, and the associated hyperbolic path for the present value weights or discount factors attached tofuture benefits and costs, merits a fuller consideration, especially as some of the projects considered in the Guide have investment horizonsexceeding 50 years. The HM Treasury Green Book (2003) includes a schedule of declining long-term discount rates for very long-term projectsbased on a starting STPR of 3.5% (the standard discount rate for normal long-term projects with investment horizons of up to 30 years). TheGreen Book also includes a table showing the marginal discount factors up to 500 years ahead. The Stern Report (2006) on Climate Change uses a0.1% per year, and discusses declining social discount rates.109See also Florio (2006) for a non-technical discussion206