Martha Bicket, a postgraduate student at Imperial College London, asks, when it comes to discount rates, how low can we go?
If you had the choice, would you prefer to receive £100 now or £150 this time next year?
Most would say it depends on how patient you are. £150 is obviously more than £100. But it also depends on how good an entrepreneur you consider yourself to be. Could you get a better rate of return if you invested the £100 yourself?
And what if you get that pay rise at work – would you prefer a £100 increase from this year or a £150 increase from next year? Getting £100 when you’re poorer arguably makes a bigger difference to your wellbeing than getting £150 when you’re already rich.
Here we start to see arguments for why the £100 now might be considered to be more valuable. It’s for reasons such as these that, even after adjusting for inflation, we still don’t necessarily consider money to have the same value at different points in time.
What discount rate does Government use for projects?
Recommended procedure in Government for assessing investments in the UK is to assume that a financial sum loses its present value at a rate of 3.5% with each year further into the future that it occurs.
This rate is called the “discount rate”, and it’s built into the way in which Government assesses the “net present value” – or overall merit – of a project, be it building a particular block of council houses, a motorway, wind farm, or school.
What have discount rates got to do with intergenerational justice?
Within the framework that Government currently uses to decide between projects, a high discount rate substantially weakens the case for investing in projects whose costs are paid now but whose benefits are felt in the more distant future, e.g. climate change mitigation and energy projects.
But a discount rate that’s too low could lead to our over-spending on future generations at the expense of people suffering today – future generations, who might, after all, turn out to be richer, more technologically advanced and more capable of coping with the costs we otherwise would have left for them. So, it’s important that we make sure we’re using the right discount rate.
Is Government using the right discount rate for assessing investments?
UK government consulted a variety of studies before coming up with its discounting guidelines and the rate of 3.5%. For example, they looked at historical growth rate trends in the UK, and individuals’ discount rates as illustrated by their saving and spending decisions in markets.
However, in a report published in 2006, The Stern Review on the Economics of Climate Change, a collection of economists suggested that, for certain types of projects, the discount rate should be much lower than 3.5%. Proponents of a lower discount rate argue that considerations of “intergenerational equity” and “greatest overall good for society” ought to override the short-term bias of current generations.
Critics of this alternative approach to discounting raise concerns about its arbitrariness and susceptibility to manipulation. They argue a rate based on people’s behaviour as revealed in the markets is more concrete, defensible, and indicative of the investment that generates the greatest good, at least in the short-run.
Choosing the right discount rate for public spending
The policy decisions made today are made by a government elected and held accountable by today’s generations. A government might therefore find it hard to champion discount rates that lie too far outside the range of public acceptability.
In my MSc thesis at Imperial College London I am evaluating the different methods by which we calculate people’s discount rates. I am also assessing the extent to which considerations of intergenerational equity might acceptably be built into the policy decision-making process, and how this might be done.
I want to know: what is our lowest socially acceptable discount rate?
Exploring your views on present-future trade-offs
Did the issues raised in this post interest you? Please contribute to my research in this area by following the link below and taking 15 minutes to answer a survey.
I’m very much looking forward to your responses!