Canadian Public Policy

The Social Discount Rate: Jenkins vs. LindAuthor(s): R. W. WrightSource: Canadian Public Policy / Analyse de Politiques, Vol. 11, No. 3 (Sep., 1985), pp. 629-630Published by: University of Toronto Press on behalf of Canadian Public PolicyStable URL: http://www.jstor.org/stable/3550517 .

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R.W. WRIGHT Department of Economics, The

University of Calgary

The Social Discount

Rate: Jenkins vs. Lind The majority of cost-benefit studies of Canadian

projects have included the assumption that the real social discount rate (SDR) is 10 per cent. This value is based on the proposition that the SDR should be a weighted average of returns associated with the three major sources of pub- lic funds (displaced private investment, private savings and foreign capital) and on Jenkins'

(1977) detailed empirical work on the subject. Burgess (1981) has challenged the Jenkins con-

clusions, arguing that the real social discount rate is closer to 7 per cent. As this debate is as

yet unresolved (Jenkins, 1981), it is fair to say that conventional wisdom in Canada is that the

'weighted average' methodology is appropriate and that the SDR is in the 7 to 10 per cent

range. However, Lind (1982) has proposed an al-

ternative evaluation procedure which among other things, recommends a 3 per cent SDR for

energy projects. This rate is reputed to reflect the true value of domestic energy supplies and to encourage the expansion of long-run produc- tive capacity.

The Canadian energy industry is likely to be attracted to the Lind proposal. However, its

adoption can have consequences which are just the opposite of those which are anticipated. The objective of this note is to explain the nature of this paradox. As a preliminary step, it is necessary to outline the role of cost-benefit studies in the evaluation of energy projects.

Most cost-benefit studies in Canada's energy industry are prepared by private companies who are required to demonstrate to provincial or federal regulatory authorities that their pro- jects are in the public interest and in doing so it has become a common practice to discount project benefits and costs at 10 per cent. Typi- cally, these projects are capital intensive and

highly levered with debt capital obtained in

capital markets outside the jurisdiction of the

regulatory authorities at real interest rates of

approximately 5 per cent. The authorities often

incorporate these financing arrangements into their evaluation process (National Energy Board, 1983:10 and Appendix D) with the result that

project costs are shifted from the construction period to the repayment period. However, this

seemingly innocent practice can have an over- whelming effect if the discount rate is in excess of the borrowing rate because costs apparently vanish. For example, $1 of construction costs translates into 57 cents when financed externally by a 20 year 5 per cent bond and discounted at 10 per cent. In some cases, this can be enough of a bonus to make an otherwise unattractive

project appear to be consistent with the public interest.

Lind proposes two fundamental changes in the conventional methodology, First, the pro- ject and the alternative from which the funds are withdrawn are each converted into the ag- gregate consumption streams they would gener- ate over time. This is accomplished by estimating the differential impact on induced and displaced investment expected to arise from each alter- native. (It is hypothesized that investment is advantageous because it leads to a multiple expansion in consumption.) The differential is then attached to the various direct costs and benefits in the form of a 'shadow price' weight. In essence, this procedure expands cost-benefit analysis from a microeconomic tool to include a set of 'externalities' related to indirect capital formation and its consequent effect on con- sumption.

The second change is that the net consump- tion streams associated with the project are discounted at the social time preference rate. In agreement with others, including Jenkins, Lind recommends use of the post-tax risk-adjusted rate of return on marketable securities which he takes to be 4.6 per cent. However, he argues that because energy projects provide an element of insurance against international price shocks while still offering returns which move in tan- dem with general economic conditions in the absence of these shocks, they should be viewed as preferred investments and discounted at the more permissive rate of 3 per cent. (The possi- bility of stable or declining world energy prices appears to be ignored.)

Canadian Public Policy - Analyse de Politiques, X1:3:629-630 1985 Printed in Canada/lmprlm6 au Canada

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If one examines the impact of using Lind's

system to evaluate levered, externally financed, private sector energy projects, the effect be- comes immediately obvious. That is, the bonus which used to exist because the SDR exceeded the real borrowing rate disappears and in fact, external financing now imposes a burden on the

project. To illustrate, consider a project costing $1 million which yields an annual net benefit of

$70,000 (prior to interest charges) for 20 years and which is financed by an externally held 5

per cent, 20 year bond. If this is evaluated using a 10 per cent SDR it is acceptable; if it is dis- counted at 3 per cent, it should be rejected.1 Paradoxically, the situation is reversed if fi- nanced internally: it is rejected with a 10 per cent rate and accepted using a 3 per cent rate.2

What is to be noted is that for the typical energy project which is financed by debt capital obtained in markets outside the jurisdiction of the regulatory authorities, the Lind procedure raises, rather than lowers the standard of accept- ance. However, the other side of the coin is that the Lind procedure offers a bonus for locally financed projects, reversing a bias which has existed in conventional cost-benefit studies using a 10 per cent, or even a 7 per cent social dis- count rate.

Notes

project yields an annual benefit of $20,000 for 20 years and a repayment cost of $1 million in the twentieth year. When this is discounted at 10%, the net present value is +$21 thousand. When discounted at 3%, the net present value is -$256 thousand. If it is assumed that the interest payments reduce tax leakages to the federal gov- ernment, these numbers would change but the conclusion would not be altered.

2 It is possible, although unlikely, that this pattern could be modified if different 'shadow price' weights were to be attached to different com- ponents of the cost and benefit streams.

References

Burgess, D.F. (1981) 'The Social Discount Rate for Canada,' Canadian Public Policy -

Analyse de Politiques, V 1:3:383-394. Jenkins, G.P. (1977) 'Capital in Canada: Its

Social and Private Performance, 1965-74,' Economic Council of Canada Discussion

Paper No. 98. (1981) 'The Public Sector Discount

Rate for Canada: Some Further Observa-

tions,' Canadian Public Policy - Analyse de

Politiques, VI 1:3:399-407.

Lind, R.C. (1982) Discounting for Time and Risk in Energy Policy, (Washington, D.C.: Resources for the Future), Chapters 2 and 12.

National Energy Board (1983) A Discussion of the Cost Benefit Methodology Used in the Gas Export Omnibus Hearing, June.

1 If leakages associated with taxes are Ignored, the

FACULTY VACANCIES The University of British Columbia

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630 R.W. Wright

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