The 1980s were great in many ways, but a 1989 discount rate is looking distinctly old-fashioned in 2020.
It may be hard to be prepared for a pandemic, but it should surely be easier to prepare for the aftermath. Governments around the country have committed to speeding up delivery of infrastructure projects to spark the recovery from recession. But that’s only a good idea if they’re the right projects. And unfortunately, for as long as governments keep on assessing projects with the wrong discount rates, we have to expect them to build the wrong projects.
The Prime Minister has emphasised the need for governments to “get out of the way and speed up progress by improving approvals processes”.
There’s no problem with this strategy; with borrowing rates at their lowest since federation, the Reserve Bank Governor has affirmed that the government is in a good position to borrow to provide fiscal support for a sustainable recovery.
The problem lies in the execution.
An important element in how infrastructure projects are assessed is the discount rate. The discount rate is the tool that puts costs and benefits occurring at different times on to a comparable footing.
Bizarrely, almost all Australian jurisdictions have opted, since at least 1989, to use a discount rate of 7 per cent for most transport and other infrastructure projects, irrespective of project risk or real interest rates.
While 7 per cent may have made sense 30 years when it was first established, it doesn’t make sense now. That’s because real borrowing rates are one of the key components of the discount rate, and they’ve fallen from 6.8 per cent in real terms in 1989 to below zero today.
Australian governments say their discount rates reflect the next-best use of the resources for that project, and with the same level of risk. The type of risk that’s relevant for discounting is the sensitivity of a project’s expected returns to the economy generally – the systematic risk – and it probably doesn’t change much over time. But the cost of money, which is usually inferred from government borrowing costs, changes a lot.
Government borrowing costs are exceptionally low today, and given that the real yield on 30-year Commonwealth bonds is around zero, plenty of people think they’re going to stay low for a long time.
Rather than a standard discount rate of 7 per cent, governments should be using rates of around 2.5 per cent for projects where the systematic risk is very low, such as buses, roads and urban passenger rail. Where the projects are a little more sensitive to the state of the economy, such as ferries and freight rail, the discount rate should be around 4 per cent. As with current practice, there should be sensitivity testing for either level of risk.
Ditching the 7 per cent in favour of rates of 2.5 and 4 per cent would change governments’ infrastructure pipelines in two important ways. First, more projects would be assessed as worth building. That’s because projects take time to build, and most benefits are only realised on completion; an artificially high discount rate treats those future benefits more harshly than a lower discount rate would. Second, the ranking of projects would change. That’s because an artificially high discount rate puts a bigger penalty on projects where the benefits are further off than it does on projects with nearer-term benefits.
Critics may say that it doesn’t really matter, that the emphasis should surely be on getting projects started even if in a perfect world we’d choose different projects. While it’s true that fiscal stimulus has its own logic, it’s also true that if governments add to the growing debt mountain, they should do so in a way that sets us up as well as possible for the future. That future almost certainly includes long-term changes to patterns of work and travel. Rolling out the old pipelines with the old methods of discounting just isn’t good enough.
Instead, governments should, right now, set new discount rates of 2.5 per cent for transport projects with very low levels of systematic risk, and 4 per cent for projects with somewhat low risk. They should review the business cases for all the major projects in their pipelines, with these new discount rates, to see whether they are robust to a range of future scenarios. With these changes, we’d be on a much better path to the “infrastructure-led recovery” that governments of all jurisdictions are chasing.
Marion Terrill is a leading policy analyst who has provided expert analysis and advice on labour market policy for the Commonwealth government, the Business Council of Australia and at the Australian National University. She is transport and cities program director at the Grattan Institute.
Comments
One response to “Time for a rethink on discount rates”
Ms Terrill: thanks. The particular issue has been debated since the early 1990s. You might like to consider some broader implications.
1. (My experience has been) discount rates, even cost-benefit analysis, determine decisions only for rats and mice transport projects which are a normal part of transport businesses. Government go-aheads for projects beyond the norm may be somewhat influenced by the rates (but I struggle to recall even one such case). What should matter in a democracy is: the basis for a Government decision is made public – analyses are conducted, published and critiqued. This is different from Governments being told they must – or pretend to – ‘follow the science’. That the public knows what discount rate is used is more important than the fact of it being in manuals used by bureaucracies.
2. It usually is thought a lowering of discount rates will bring forward projects because assessed benefits will increase. Yet assessed costs should also increase particularly for those projects which eschew interoperability or that lock-out future options, such as other uses of corridor. In those cases a a lower discount rate could demonstrate non-viability. Sydney Metro and airport rail in Melbourne are examples – where opportunities of regional rail, and alternative settlement patterns, are to be made prohibitively more costly by urban transport project design. This effect is typically ignored in proposals and advice put to Government and in ‘independent reviews’. It is of far greater significance than choice of rate cf. Paris tunnels late 1800s with partial rectification taking well over a century. Or Australia’s break of rail gauge.
3.Behaviours in infrastructure decision making, are likely to show elsewhere in public policy (and vice versa). The pandemic provides examples including: failure of the Commonwealth to exercise its functions and purpose, preferring to be the ‘rich uncle’ bestowing gifts – a criticism Mr Fraser and I have made repeatedly about transport. Consequences in the pandemic – quarantine failures, illegalities by the States and ‘border wars’ – are symptoms of a malaise also present in transport. The malaise can be seen by e.g. a comparing the eagerness of writing innocuous project assessment manuals against abetting, even supporting nationally damaging projects – in 2 above. The importance of getting transport things right extends beyond transport. Given that, any argument about changing transport specific discount rate might best be placed in a wider context, with reference to the role and behaviour of the Commonwealth Government.
Thanks again