Discounting Future Benefits and Costs Eliane Catilina, Ph.D. U.S. Environmental Protection Agency Office of Pollution Prevention and Toxics Chemicals, Economics and Policy Analysis Division

Discounting Future Benefits and Costs Discounting renders costs and benefits that occur in different time periods comparable by expressing their values in present terms. Discounting factor reflects: The amount of time between the present and the point at which these changes occur. The rate at which consumption is expected to change overtime in the absence of policy. The rate at which the marginal value of consumption diminishes with increased consumption, and The rate at which the future utility from consumption is discounted at time.

Discounting Future Benefits and Costs Social Discounting: Discounting from the broad society-as-a-whole that is embodied in benefit-cost analysis. Private discounting: discounting from specific limited perspective of private individuals or firms. Intragenerational (or conventional) discounting: Discounting over a relatively short term. Decades long time frame but doesn’t explicitly confront impacts on unborn generations. Intergenerational discounting: Much longer time horizon. Impact generations to come.

Discounting Future Benefits and Costs Sensitive issues surround the choice of discount rate: The distinction and potential confounding of efficiency and equity considerations. The difference between consumption and utility discount rates. “Perspective” approaches vs. “descriptive” approaches to selecting discount rate. Uncertainty about future economic growth and other conditions.

Mechanism Summarizing Present and Future Costs and Benefits There are several methods for discounting future values to the present, the most commons are: Net Present Values Net Future values Annualized Values

Net Present Value

Net Present Value The NPV can be estimated using real or nominal benefits, costs, and discount rates. Costs and benefits can be estimated separately and then compare them to arrive at the net present value. It’s important to use the same discount rate for cost and benefit. It’s important to state how time periods are designated and when, within each time period, costs and benefits accrue.

Net Present Value  

Net Present Value  

Net Present Value Alternative Methods to Estimating Terminal Values. Terminal Values Based on Simple Projections. Terminal Values Based on Salvage or Liquidation. Existing Values Based on Depreciated Value. Estimating Values Based on Initial Construction Cost.

Net Present Value  

Annualized Values Annualized values is the amount one would pat at the end of each period t so the sum of all payments in present value terms equals the e original stream of values. Producing annualized values of cost and benefits is useful because it converts the time vary stream of values to a constant stream. Comparing annualized costs to annualized benefits is equivalent to comparing the present values of costs and benefits. Costs and Benefits each may be annualized separately by using a two-step procedure. To annualize cost, the present value of costs is calculated using the formula for net benefits, except the stream of costs alone, not the net benefits, is used in the calculation. The Exact equation for annualizing depends on whether or not there are any costs at time zero (i.e., at t = 0)

Annualized Values  

Annualized Values Annualization of costs is also useful when evaluating non-monetized benefits, such as reductions in emissions or reduction of health risks, when benefits are constant over time. The average cost-effectiveness of a policy or policy option can be calculated by dividing the annualized cost by the annual benefit to produce measure of program effectiveness, such as the cost per tons of emissions avoided.

Comparing the Methods The methods are not different ways to determine the benefits and costs of a policy, but rather are different ways to express and compare these costs and benefits in a consistent manner. For a given stream of net benefits, the NPV will be lower with higher discount rate, the NFV will be higher with higher discount rates, and the annualized value may be higher or lower depending on the length of time over which they are annualized. Rankings among regulatory alternatives are unchanged methods.

Sensitivity of Present Value Estimates to discount Rate The impact of discounting streams of benefits and costs depends on the nature and timing of benefits and costs. The discount rate is not likely to affect the present value of the benefits and costs for those cases in which: All benefits occur in the same time. Cost and Benefits are largely constant over time frame. Cost and Benefits of a policy occur simultaneously and their relative values do not change over time. Discounting can substantially affect the net present value of costs and benefits when there is a significant difference in the timing of costs and benefits, such as with policies that require large initial outlays, or that have long delays before benefits are realized.

Potential Impact on Discount “Suppose the benefits of a given program occur 30 years in the future and is valued (in real terms) at $5 billion at that time. The rate at which we discount the $5 billion future benefits, however, can dramatically alter the economic assessment of the policy: $ 5 billion 30 years in the future discounted at 1% is $3.71 billion, at 3% it is worth $2.06 billion, at 7% it is worth $657 million, and at 10% it is worth only $287 million. In this case, the range of discount rates generates over an order of magnitude of difference in the present value of benefits. Longer time horizons will produce even more dramatic effects on policy’s net present value. For a given present value of costs, particularly the case where costs are incurred in the present and therefore not affected by the discount rate, it is easy to see that the choice of the discount rate can determine whether this policy is considered on economic efficiency grounds to offer society positive or negative net benefits.” (U.S EPA, 2010. Guidelines for Preparing Economic Analysis)

Some Issues in Application Analytical components that need to be considered when discounting: Risk and Valuation Placing Effect in time Length of the analysis

Background and Rationale of Social Discounting The analytical and ethical foundation of the social discount literature rests on the traditional test of a “potential” Pareto improvement in social welfare. This framework casts the consequences of government policies in terms of individuals contemplating changes their own consumption (broadly defined) over time. Trade offs (benefits and costs) in this contexts reflect the preferences of those affected by the policy. The time dimension of those tradeoffs should reflect the intertemporal preferences of those affected. Social discounting should seek to mimic the discounting practices of the affected individuals.

Background and rationale of Social discounting Thank you!