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Coastal Ecosystem Restoration
This website is archived and content of these pages are no longer maintained. Discounting and Time PreferenceIntroduction
When weighing the benefits and costs of coastal restoration projects and other environmental management programs, the selection of a discount rate is a key consideration and often a source of controversy. What is a discount rate? The discount rate is the rate at which society as a whole is willing to trade off present for future benefits. When weighing the decision to undertake a project with long-term benefits (e.g., wetland protection programs) versus one with short-term benefits and long-term costs (e.g., logging forests near aquatic ecosystems), the discount rate plays an extremely important role in determining the outcome of the analysis. Indeed, a number of reasonable decision measures (e.g., net present value, benefit-cost ratio, internal rate of return, return on investment) depend critically on the chosen discount rate. Why are discount rates needed? Because a dollar received today is considered more valuable than one received in the future. There are four primary reasons for applying a positive discount rate. First, positive rates of inflation diminish the purchasing power of dollars over time. Second, dollars can be invested today, earning a positive rate of return. Third, there is uncertainty surrounding the ability to obtain promised future income. That is, there is the risk that a future benefit (e.g., enhanced fish catches) will never be realized. Finally, humans are generally impatient and prefer instant gratification to waiting for long-term benefits. Discount rates are used to compress a stream of future benefits and costs into a single present value amount. Thus, present value is the value today of a stream of payments, receipts, or costs occurring over time, as discounted through the use of an interest rate. Present value calculations of benefits and costs are then compared to determine benefit-cost ratios. For example, if the present value of all discounted future benefits of a restoration project is equal to $30 million and the discounted present value of project costs totals $20 million, the benefit-cost ratio would be 1.5 ($30 million / $20 million), and the net benefit would be $10 million ($30 million — $20million). Any benefit-cost ratio in excess of 1.0 or net benefit above 0.0 demonstrates positive economic returns to society. Note that values used for benefit-cost analysis are often amortized over the project time horizon, yielding annualized benefits and costs. This practice allows for comparison of projects with different timeframes. Mathematically, the present value of a future benefit or cost is computed based on Equation 1.
Where PV = the present value of a benefit or cost, FV = its future value, i = the discount rate and n = the number of periods between the present and the time when the benefit or cost is expected to occur. The following example illustrates how the equation is used. Assume that a future benefit of a salmon habitat restoration project is an expanded catch valued at $10,000,000 in Year 10. Here is how we would calculate the present value of that benefit, assuming a 3 percent discount rate.
The present value will vary widely based on the discount rate used in the analysis. For example, use of a 10 percent discount rate would reduce the present value of the aforementioned benefit associated with salmon habitat restoration to $3,855,433, a 48 percent reduction in present-value benefits. High discount rates, therefore, tend to discourage projects that generate long-term benefits (e.g., wetland restoration) and favor those that create short-term benefits and significant long-term costs (e.g., damming rivers). Another way of thinking about discount rates is as the
inverse of compound interest. That is, whereas compounding measures how
much present-day investments will be worth in the future, discounting
measures how much future benefits are worth today. The Rationale for DiscountingDiscounting reflects how individuals value economic resources. Empirical evidence suggests that humans value immediate or near-term resources at higher levels than those acquired in the distant future (NOAA 1999). Thus, discounting has been introduced to address the issues raised by the existence of this phenomenon, which is known as time preference. Time preference is of significant interest to economists but the weight it is given depends on the discount rates used to perform present-value calculations. To understand better how time preference works, consider the perspective of the residents who fund a local public project. Most residents would exhibit some degree of impatience and value short-term benefits more highly than those that accrue over the long-term. For example, some of the current residents who bear the costs of the project may die or move out of the local area before the long-term benefits are realized. Many of the benefits would accrue to individuals who later move into the area but played no part in the funding of the project. It may not be possible or practical for those who invested in the project to receive compensation from the ultimate beneficiaries. In addition to time reference, there are a number of justifications for discounting the value of future benefits and costs. First, inflation is common within most economies. Inflation is a sustained increase in the general price level. The rate of inflation reflects the pace at which general prices are increasing. Deflation is the opposite of inflation or a sustained decline in the general price levels. Deflation rarely occurs. In fact, the last period of sustained deflation in the United States occurred during the Great Depression between 1929 and 1933. Due to the effects of inflation, $10 could be exchanged for more goods and services today than it could be in 10 years. For example, at a 3 percent rate of inflation, the real purchasing power of $10 will decline by nearly 26 percent in the next 10 years. Thus, economists are generally concerned with real, as opposed to nominal, values. Nominal values reflect value without accounting for inflation or applying a discount rate. The real value of a benefit is equal to its nominal value adjusted for inflation. The real discount rate is the nominal rate minus the expected rate of inflation. Inflation is a primary reason for discounting; however, independent of inflation, discounting is an import tool for assessing environmental benefit streams. Discount rates also reflect the opportunity cost of capital. The opportunity cost of capital is the expected financial return forgone by investing in a project rather than in comparable financial securities. For example, if $10 is invested today in the private capital markets and earns an annual real rate of return of 10 percent, the initial $10 investment would be valued at $25.94 at the end of 10 years. Therefore, discount rates reflect the forgone interest earning potential of the capital invested in the public project. The real opportunity cost of capital is often considered to be higher than the pure time preference rate. The former reflects the productivity of capital; the difference over time is not between the value of a dollar’s worth of services consumed now and a dollar’s worth of services consumed later, but rather a dollar’s worth of services consumed now and the higher future consumption made possible by the return on investment. Third, public projects involve uncertainty and risk. When public projects are undertaken, including those that involve coastal or wetland restoration, there is a chance that future benefits will not be fully realized or realized at a higher level than estimated (there are also uncertainties associated with costs). For example, natural disaster could undermine efforts to restore wetland habitat, thus reducing or eliminating the future benefits that a restoration project would have generated. The further out into the future these benefits are expected to be realized, the greater the risk that some unexpected event or factor will occur and diminish the value of the future benefit. This uncertainty argues either for reducing the benefits and the costs of a project to reflect risk, or else adding a risk premium to the discount rate, much as “junk bonds” have a higher interest rate than less risky securities. Usually, the preferred method for dealing with uncertainty is directly to adjust benefits and costs (or to perform the analysis quantifying the uncertainty and explicitly considering it in the estimates of benefits and costs), not change the discount rate. Fourth, humans prefer near-term to future benefits. The inability to defer gratification results in decisions that are slanted toward obtaining near-term benefits, often at the cost of those available in the long-term. Regardless of whether this represents a sound policy, economic value is established based on human preferences, and humans prefer near-term benefits to those that accrue in the distant future (see An Economic View of the Environment). For these and other reasons, there is general agreement among
economists that discounting is necessary when comparing a stream of
benefits and costs accruing over a number of years. Selecting a Discount RateThe discount rate is a key determinant in the outcome of a benefit-cost or damage valuation study. Therefore, it is important to understand the rationale for choosing one discount rate over another. At one extreme, an infinitely high discount rate would render all future actions meaningless. At the other extreme, using no discount rate means that benefits today are no more valuable than benefits experienced 100 years from now. Neither of these extreme views is correct. The real question is, "What discount rate best reflects the time preference, productivity, and risk of this project?" Regardless of the discount rate chosen, it is imperative that a single rate be used to discount all benefit and cost elements. Some philosophers and ethicists (and some economists) argue that present generations have the moral obligation to protect the interests of future generations, because these future recipients of benefits are as yet unborn and cannot express their own (future) preferences. A more optimistic counterargument is that investments made in the economy today are likely to increase the future wealth of our descendents, giving them greater scope to exercise any preferences for environmental protection, so long as environmental damage is reversible (see Irreversibility, Sustainability, Safe Minimum Standard). The argument follows that a zero discount rate would ensure intergenerational equity by preventing the present generations from ignoring the long-term environmental and other consequences of present-day economic activity. Utilitarian and some other economists have taken this argument one step further by arguing that discounting is ethically indefensible and is, indeed, a “polite expression for rapacity” (Harrod 1948). Proponents of the zero discount rate argue that discounting can almost entirely devalue the economic impact of even catastrophic environmental events occurring outside a 50-year time horizon. For example, the present value of a catastrophic event occurring 50 years from today would be valued at less than 1 percent of its future value (assuming a 10 percent discount rate). The ethical arguments against discounting are compelling; however, the existence of inflation, time preference, and the opportunity cost of capital suggests that a positive discount rate better reflects societal preferences. The social rate of time preference is the rate at which society is willing to substitute present for future consumption of natural resources. The federal opportunity cost of capital and the rate of productivity growth are commonly used as proxies for the social rate of time preference. The argument for using the federal opportunity cost of capital as a proxy for the social rate of time preference is that in the absence of the public project, the federal government could put the funds to productive use reducing the national debt. When using the federal cost of capital, the generally accepted practice is to apply the effective yield on comparable-term Treasury securities (e.g., 20-year Treasury bonds for a study with a 20-year analysis timeframe). During the decade of the 1990s, the average 10-year Treasury bond rate was 6.01 percent whereas inflation averaged 2.88 percent. Thus, the real rate of interest on Treasury bonds was roughly 3.13 percent during the 1990s (Bellas and Zerbe 2003). Social policy is also concerned with an equitable distribution of consumption over time. Based on this premise, the rate of productivity growth can be used as a proxy for the social rate of time preference. This policy reflects the opportunity cost argument that the incremental or marginal benefit to the country generated by the public project should grow as fast as the productive capacity of industry. From 1990 to 2003, real Gross Domestic Product (GDP) grew by 2.96 percent (BEA 2004). Thus, using productivity over that period as the basis of the discount rate generates a roughly 3.0 percent rate. The National Oceanic and Atmospheric Administration (NOAA) recommends using the social, or consumer, rate of time preference for discounting interim service losses and restoration gains when scaling compensatory restoration (NOAA 1999). NOAA has adopted a 3.0 percent discount rate as a proxy for the social rate of time preference. When discounting restoration and assessment costs, NOAA recommends that trustees use the rates on U.S. Treasury securities issued for a comparable term relative to the analysis period. Since 1992, the federal Office of Management and Budget (OMB)
has recommended a 7 percent real discount rate for the analysis of
federal programs. The OMB, in setting the discount rate at 7 percent,
notes that “this rate approximates the marginal pretax rate of return on
an average investment in the private sector” (OMB 1992). The OMB rate
is based on the assumption that public investments displace both private
investments and consumption. Therefore, based on the principle that tax
dollars displace private investment, the rate of return on private
sector investment could also serve as the basis of the discount rate.
The rate of return on private sector investment and the corporate
after-tax weighted cost of capital are commonly used as discount rates
when performing financial analysis affecting private industry. Compared
with public instruments, corporate stocks and bonds average higher rates
of return due in part to the higher risk inherent in private sector
investment. From 1926 to 1997, the arithmetic mean of real pre-tax
returns on stocks was 9.7 percent. The real post-tax rate of return on
stocks during this time period declines to roughly 7 percent when
assuming a 30 percent personal tax rate (NOAA 1999). The U.S. Treasury
defines a specific discount rate for planning and development of water
resource-related infrastructure and for repayment of debts associated
with this type of infrastructure. The prescribed Treasury discount rate
is updated annually.
Applying a Discount RateTo better understand how discount rates are applied, consider the following illustrative case. Assume that a marine ecosystem is threatened by polluted runoff (heavy metals and other toxins) from development along the coastline and adjacent islands; waste from sewage, detergents, and fertilizers; destructive fishing methods; and offshore oil drilling. The convergence of these environmentally destructive activities threatens the viability of reefs and seagrass beds, and threatens the long-term sustainability of the fish and other seafood harvests. In response, the federal government is considering establishing a National Marine Sanctuary to provide comprehensive protection of the marine environment (Figure 2). As a result of government intervention, there would be both direct economic benefits (e.g., more ecotourism, enhanced seafood harvests, better bird watching, a fishing catch that is sustainable in the long-term) and indirect benefits including the preservation of cultural and historic sites (e.g., lighthouses and ship wrecks), as well as economic costs. The costs associated with government intervention could include productivity losses incurred by industry as a result of the prohibition on off-shore drilling, waste dumping, and net fishing. Finally, private industry could be required to purchase costly equipment to comply with new regulations related to the treatment of industrial waste products. These purchases are a form of abatement cost. An abatement cost is a cost borne by industry to mitigate the damaging impact of an environmental externality that the industry has created. Table 1 examines the benefits and costs associated with the government action. The cost to industry in the form of lost productivity, abatement costs, and the reduction of fishing harvests (assuming fish harvests are reduced in the first seven years of the program during which time net fishing is replaced with hook-and-line fishing methods) totals $175.0 million, using a 7 percent discount rate. Conversely, the present value of the benefits associated with establishing the marine sanctuary (tourism, fishing, seafood harvests, and recreation) are estimated at $163.8 million, based on a 7 percent rate of discount. Therefore, the present value of total benefits falls short of the present value of lost production during the 20-year study timeframe, resulting in a benefit-cost ratio of 0.94 (total benefits / total costs). The outcome of the analysis, however, is highly sensitive to the discount rate. When a 3 percent rate is used, government intervention would yield a benefit-cost ratio in excess of 1.0. When a 10 percent discount rate is used, present value costs exceed benefits and result in a benefit-cost ratio of 0.85. The high discount rate reduces the benefit-cost ratio, because the costs associated with abatement and the reduction in fish harvests are experienced disproportionately during the first half of the 20-year analysis timeframe, whereas the tourism and recreational benefits of the sanctuary are relatively low in the near-term but grow steadily throughout the study timeframe. Figure 3 demonstrates this point graphically by examining the cumulative net benefits of total benefits and costs. As shown, the regulations fail to generate net benefits until Year 18. Prior to Year 18, the total cumulative costs associated with the program exceed total benefits. From Year 18 forward, however, the decision to establish a marine sanctuary and impose stronger regulations on industry would be expected to reap positive net benefits to society. But what happens to the costs to industry if the habitat degrades and there are no fish to catch in the future. Table 1 demonstrates that the illustrative analysis is beginning to capture this point because beginning in Year 8, the catch under the sanctuary alternative exceeds that realized under the no-action alternative. In the absence of the sanctuary, the damage caused by the various activities described previously will lead to a decline in the fish population and long-term revenue to commercial fisherman. Because the damage will mount over time, the selection of a longer time horizon will result in a higher benefit-cost ration due to the long-term benefits associated with protecting the marine habitat and preserving the sustainability of future fish runs. It is important to note that there is a misconception that a project with the highest benefit-cost ratio should be selected when, in fact, the project that yields the highest net benefits to society is most desirable. In the example demonstrated in Table 2, the benefit-cost ratio is maximized with Alternative C but welfare is maximized with Alternative E. The selection of the plan with the highest benefit-cost ratio (Plan C) would result in $7 million in forgone net benefits, which would have been realized if Plan E had been selected ($182 million in net benefits for Plan E – $175 million for Plan C). Table 1. Benefits and Costs of Establishing a National Marine Sanctuary
Table 2. Benefit-Cost Ratios and Net Benefits for Illustrative Restoration Projects ($Millions)
ConclusionDebate in the literature on discounting has often focused on how to select the correct discount rate. In reality, there is no one, single accepted discount rate used by all economists when performing benefit-cost analysis. Due to the nature of time preference and the opportunity cost of capital, however, economists generally agree that, as ethically challenging as the decision can be, a positive discount rates should be used when valuing future benefits and costs. In practice, discount rate are generally prescribed by the funding agency. Political concerns, in some cases, are considered when
discount rates are chosen. However, arbitrarily selecting discount rates
to meet short-term political goals could have long-term consequences.
For example, high discount rates tend to discourage projects with high
up-front costs and long paybacks, such as dam construction and new
mineral extraction operations, but they also discourage coastal
restoration and wetlands protection programs. Conversely, low discount
rates encourage coastal restoration and wetland protection programs but
also encourage dam construction and mineral extraction. Regardless of
the rate chosen, it is important to remember that the discount rate is a
key determinant in the outcome of an analysis, and for each project, a
single rate must be applied to all future benefits and costs. References*Some of the documents below are in Adobe portable document format (PDF) and requires Adobe Acrobat Reader.BEA (Bureau of Economic Analysis). 2004. "Gross Domestic Product." Web site. Available at: http://www.bea.gov/bea/dn/home/gdp.htm Bellas, A., and R. Zerbe. 2003. A Primer for Benefit Cost Analysis. Working Paper. Seattle, Washington . Available at: http://faculty.washington.edu/bellas/cba/index.html Harrod, R. 1948. Towards a Dynamic Economy. St. Martin 's Press. London, UK. NOAA (National Oceanic and Atmospheric Administration). 1999. Discounting and the Treatment of Uncertainty in Natural Resource Damage Assessment: Technical Paper 99-1. Silver Spring, MD. Available at: http://www.darp.noaa.gov/library/pdf/discpdf2.pdf OMB (Office of Management and Budget). 1992. Guidelines and Discount Rates for Benefit-Cost Analysis of Federal Programs. OMB Circular A-94. Washington, D.C. Available at: http://www.whitehouse.gov/omb/circulars/a094/a094.pdf Additional Information SourcesEnvironmental Protection Agency. 2000. Guidelines for Preparing Economic Analyses. EPA 240-R-00-003. Washington, D.C. Available at: http://yosemite.epa.gov/ee/epa/eed.nsf/webpages/Guidelines.html/$file/Guidelines.pdf Greeley-Polhemus Group, Inc. 1991. National Economic Development Procedures Manual — Overview Manual for Conducting Economic Development Analysis. IWR Report 91-R-11. U.S. Army Corps of Engineers. Fort Belvoir, VA. Available at: http://www.iwr.usace.army.mil/iwr/pdf/91r11.pdf Hanley, N., and C. Splash. "Discounting and the Environment." In: Cost Benefit Analysis and the Environment, Hanley, N. and C. Splash eds. Edward Elgar. Northampton, MA. Harrington, K., and T. Feather. 1996. Evaluation of Environmental Investments Procedures: Overview Manual. IWR Report 96-R-30. U.S. Army Corps of Engineers. Alexandria, VA. Available at: http://www.iwr.usace.army.mil/iwr/pdf/96r30.pdf Hartwick, J., and N. Olewiler. 1998. The Economics of Natural Resource Use. Second Edition. Addison Wesley Longman. New York, NY. Lazo, J., G. McClelland, and W. Schulze. 1997. "Economic Theory and Psychology of Non-use Values." Land Economics, Volume 73, Number 3. Pages 358 to 371. Salant, S. 1995. "The Economics of Natural Resource Extraction." The World Bank Research Observer, Volume 10, Number 1. Pages 93 to 109. Von Tongeren, J. 1993. Integrated Environmental and Economic Accounting: A Case Study for Mexico. The World Bank for CIDIE. London, UK. |
