Discount Rates

This article looks at the benefits of using discount rates to encourage water conservation, and explores three reasons water suppliers should consider them. First, DWR in the past has required water suppliers wishing to tap bond-financed grant funds, such as, Proposition 50 and other such funding sources to use a real discount rate of 6% in their proposals. Second, water suppliers are no longer operating in a world where they can opt out of conservation on cost-effectiveness grounds. Third, it makes little conceptual sense to use different discount rates, one for DWR-funded projects and another for internally funded projects.

Discount Rates and Water Conservation

To undertake least-cost planning, water suppliers must be able to rank future supply options in terms of their level of cost-effectiveness. But, how should one compare different supply options on an apples-to-apples basis when each is potentially associated with a different time profile of costs and water supply yields? A method devised to accomplish this is called discounting, whereby all initial and future costs and water supply yields of a supply program are expressed in terms of their present-day values. Once this is done, costs and supply yields can then be easily compared across programs. A key input required to perform the discounting is called the discount rate. Selection of an appropriate discount rate is the only topic covered here. For a full description of how to apply a discounting framework to a complex stream of costs and water supply yields spanning multiple years, please refer to other appropriate CUWCC products[1].

Discount rates are meant to capture the time value of money. Individuals are willing to invest some portion of their current income only if this investment (deferred present consumption) is likely to yield greater income (greater consumption) in the future. Or to put it differently, individuals value current consumption more than future consumption. Were this not true the concept of interest would not exist. An individual willing to forgo $1 of present consumption only if promised $1.1 a year later indicates through his behavior that his nominal annual discount rate is 10%. One could turn this statement on its head and say that the present value of $1.1 obtained next year is $1 in today’s terms, which is really the key to performing cost-effectiveness analyses. The real discount rate, however, is equal to the nominal discount rate minus the rate of inflation. If we assume annual inflation is running at 5% in the above example, then asking for $1.1 next year to replace $1 of deferred consumption this year implies that really speaking the individual only wants the purchasing power of $1.05 in terms of today’s dollars to be made whole for deferring $1 of present consumption. In others words, his real discount rate is roughly 5%. When cost-effectiveness calculations are performed using cost and price data in real terms, the real discount rate must be used; and when performed using nominal cost and price data, the nominal discount rate must be used. The former practice is more common.

How Should a Water Supplier Select its Discount Rate?

This is a vexed question with potentially many different answers. A water supply project may be funded via new bond issues. Some might argue in favor of the bond interest rate to be used as the discount rate. However, bond interest rates reflect not just the time value of money but also perceptions about the riskiness of the bond issuer relative to risks associated with competing investment alternatives. A bond backed by the full faith and credit of the US government requires a lower interest rate to sell, than that issued by the State of California, which in turn is lower than that issued by a water utility. Even if this conundrum could be easily solved, what discount rate would one select for capital improvements or conservation programs funded via water rates instead of bonds? Therefore, while bond interest rates are useful for the purpose of financial analyses, they should not be confused with the discount rate.

Although the Federal government offers guidance about discount-rate selection for Federal water projects[2], for the purpose of evaluating cost-effectiveness of water conservation programs, we think guidance issued by the California Department of Water Resources (DWR) is perhaps more useful[3]. DWR is at present using and recommending a real discount rate of 6%, “which approximates the marginal pretax rate-of-return on an average investment in the private sector in recent years.” In other words, DWR is benchmarking its discount rate to the opportunity cost of private capital, in essence expressing a preference for investments made in the water industry to be at least as attractive as investments made in private capital markets as a whole.

Three Reasons for Discount Rates

While the validity of DWR’s recommendation can be debated, there are three key reasons why water suppliers would do well to stay consistent with DWR’s guidance, now and in the future. First, DWR in the past has required water suppliers wishing to tap bond-financed grant funds, such as, Proposition 50 and other such funding sources to use a real discount rate of 6% in their proposals. Although DWR may revise this number in the future, it is unlikely to stop demanding consistency, crucial for maintaining an even playing field.

Second, water suppliers are no longer operating in a world where they can opt out of conservation on cost-effectiveness grounds. SB x7-7 has changed the existing paradigm, requiring water suppliers with water demand greater than 100 GPCD to lower their potable water use. Although suppliers have a great deal of leeway in how they choose to meet their future GPCD targets, the only purpose of cost-effectiveness analyses in such a paradigm is to rank-order different alternatives. Ultimately, a water supplier has to implement all alternatives from the most cost-effective to the one that just allows it to meet its GPCD target regardless of how attractive or unattractive that last option is. Rank-ordering of alternatives is generally not very sensitive to the discount rate.

Third, it makes little conceptual sense to use different discount rates, one for DWR-funded projects and another for internally funded projects. To maintain a valid apples-to-apples comparison across all evaluated alternatives it is necessary to use the same discount rate.

Conclusion

For all these reasons, we recommend that water suppliers stay consistent with DWR’s guidance using a 6% real discount rate for now, or until DWR modifies its guidance in the future. However, it would also be a good idea for suppliers to conduct sensitivity analyses to verify that the rank ordering of their alternatives does not materially change under lower discount rate assumptions, say, 2-3% in real terms.

Footnotes

  1. For example, the Council has developed a Cost-Effectiveness Analysis (CEA) Tool (spreadsheet and documentation) for its members that can be used to run these sorts of analyses.
  2. See Economic and Environmental Principles and Guidelines for Water and Related Land Resources Implementation Studies adopted by the US Water Resources Council in 1983 and Circular A-94: Guidelines and Discount Rates for Benefit-Cost Analysis of Federal Programs first published by the President’s Office of Management and Budget in 1992, but updated periodically.
  3. Department of Water Resources, Economic Analysis Guidebook, 2008.
Facts about "Discount Rates"
Has end user subjectResource conservation professionals +
Has introductionThis article looks at the benefits of usin
This article looks at the benefits of using discount rates to encourage water conservation, and explores three reasons water suppliers should consider them. First, DWR in the past has required water suppliers wishing to tap bond-financed grant funds, such as, Proposition 50 and other such funding sources to use a real discount rate of 6% in their proposals. Second, water suppliers are no longer operating in a world where they can opt out of conservation on cost-effectiveness grounds. Third, it makes little conceptual sense to use different discount rates, one for DWR-funded projects and another for internally funded projects.
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