Time for a rethink on discount rates

Sep 17, 2020

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.

Share and Enjoy !

Subscribe to John Menadue's Newsletter
Subscribe to John Menadue's Newsletter


Thank you for subscribing!