ABARES Working Paper
Published 4 April 2022
Authors: Simon Hone, Peter Gooday, Ahmed Hafi and Jared Greenville
There is considerable debate around discount rates and the treatment of risk in economic analysis. Since the 1980s, most government economic appraisal guidelines in Australia have adopted a consistent approach set out in government economic appraisal guidelines. However, support for this position has eroded over time. Critics have argued that the discount rate should be updated to reflect changing economic conditions and suggested, more fundamentally, that the theoretical basis of the standard approach is flawed. If these criticisms hold, we are likely to be underestimating the merits of long-term projects versus short term projects and the merits of projects that reduce risk versus projects that increase risk, with implications for the quality of investment decisions. This report explores both sides of the debate to provide rigorous and practical guidance on how economists should approach discount rates and the treatment of risk in their analysis of agricultural projects.
We need to discount future costs and benefits. One of the motivations for discounting is to account for the opportunity cost of capital. We do not want to invest in a project if it means forgoing a better alternative. The standard approach is to discount based on the (real) expected return on the alternative investment. There are several ways to define the alternative investment and this affects the choice of discount rate. Government economic appraisal guidelines tend to define the alternative as an investment in private assets across the economy. The historical long run return on private investment across the Australian economy has been around 7 per cent (or slightly higher). This is the rationale for the recommended ‘central case’ discount rate of 7 per cent in most guidelines.
But the standard approach is not always a good approximation. In particular, it does not account for differences in riskiness between the proposed project and the alternative investment. For example, a zero-risk agricultural project with an expected return of 5 per cent might be preferred to a medium-risk alternative investment with an expected return of 7 per cent. However, the standard approach will always recommend the medium-risk alternative investment, given the higher expected return. Some economists argue that a pragmatic alternative to the standard approach is to adjust the discount rate to account for project risk. However, it only provides a good approximation under restrictive conditions. A better approach is to address the time value of money (value of a dollar in the future relative to a dollar now) and risk separately. Where the costs and benefits are not known with certainty, estimate the certainty equivalents for the agricultural project in each year. Then discount the certainty equivalents based on the (real) risk-free discount rate.
To demonstrate the theoretically correct approach, we revisited a previous ABARES biosecurity application. Under the theoretically correct approach, citrus canker is estimated to cost growers $320 million in present value terms over the next 50 years. By contrast, under the standard approach, citrus canker is estimated to cost growers just $80 million. Hence, the standard approach underestimates the costs by hundreds of millions of dollars in the case of citrus canker. This can have real world consequences, including failing to make worthwhile investments to limit the arrival or spread of citrus canker because we are substantially underestimating the avoided costs from such investments. The application also shows that the theoretically correct approach can be straightforward to apply.