Question

11. Explain discount rate for government projects, rates based on returns in the private sector and social discount rate.

12. describe discounting and the economics of climate change and government discounting in practice.

Answer 1

ANSWER 11.

Discounting is based on the principle that people prefer to receive goods and services in present rather than later. That is known as ‘time preference’.
For individuals, time preference can be measured by the real interest rate on money lent or borrowed.
In other investments, people invest at fixed, low risk rates, hoping to receive more in the future to compensate for
the deferral of consumption now. These real rates of return give some indication of their individual
pure time preference rate. Society as a whole also prefers to receive goods and services sooner rather than later, and
to defer costs to future generations. This is known as ‘social time preference’so, the ‘social time preference rate’ is
the rate at which society values the present compared to the future.
The social discount rate is defined as the social rate of time preference i.e. the rate at which society would trade a
unit of benefit between the present and the future. Standard financial appraisal practice within private water
companies would almost certainly apply private discount rates, set to reflect their real opportunity cost of
capital (typically around 5-6%, although this can vary substantially). Thus an issue to resolve will be when the
application of social discount rates may be merited compared to private discount rates.
The social time preference rate has two components:

• The rate at which individuals discount future consumption over present consumption, on the assumption that no change in per capita consumption is expected, represented by (ρ)
• An additional element, if per capita consumption is expected to grow over time, reflecting the fact that these circumstances imply future consumption will be higher relative to the current position and thus have lower marginal utility (based on the concept of diminishing marginal utility – as income or wealth increases, the increase in utility is less than proportionate. This effect is represented by the product of the annual growth in per capita consumption (g) and the elasticity of marginal utility of consumption (μ) with respect to utility.

The discount rate for government projects has critical implications for federal budgets, for regional development, for choices for the environment and for the size of government.

• Too high an SDR can mean under-investment in social programs; smaller public sector.
• Too low an SDR can mean over-investment; larger public sector

Thus, the choice of discount rates can have ramifications that transcend the mathematics.

The social time preference rate, r, is the sum of these two components r = ρ + μ*g