362. BCA criticisms 3: “discounting is bad”

Number 3 in my series on criticisms of Benefit: Cost Analysis (BCA) addresses discounting, the procedure used to compare benefits and costs that occur at different points in time. Sometimes people are critical of discounting because they feel it leads to objectionable BCA results. (There is a video version of the post below, if you prefer.)

The benefits and costs of a project or policy typically occur at different times. The most common pattern is for costs to be relatively high early on and benefits to be relatively high later on (although any other pattern is possible). There is often an initial phase of relatively high investment to get a project established and a delay (for various possible reasons) until the main benefits kick in. Discounting is economists’ answer to the question, how can we validly compare costs that are incurred today with benefits that will be received in say 50 years’ time.

One obvious adjustment is for inflation, but that’s not sufficient, because spending money sooner rather than later has an additional cost – an “opportunity cost”.  There are various factors affecting this opportunity cost, but the two main ones are as follows. Firstly, if you spend money on project X you have to give up spending it on whatever it would otherwise have been spent on. If it would have been invested in Project Y, then the rate of return on project Y is the opportunity cost of investing in project X. You can think of that rate of return as being like an interest rate earned from the investment in project Y.

Secondly, people prefer to get good things sooner rather than later. This impatience is reflected in the interest rate they are willing to pay on borrowings to fund their consumption. If Project X is funded with resources that would have been spent on consumption, there is an opportunity cost because the people now have to either delay that consumption or borrow money to avoid delaying it. That opportunity cost can be estimated as the interest rate that would be charged on borrowing money to avoid the delay.

So, either way, there is sort of an interest cost on up-front costs, and this interest cost compounds over time. What discounting implicitly does is add in this interest cost (the opportunity cost of capital) on top of the more obvious project costs. The way the discounting calculations are done (by scaling down the future benefits rather than scaling up the current costs) somewhat obscures the fact that this is what is happening, so even economists don’t tend to think about it this way, but that is the logic behind discounting.

It’s the compounding effect I mentioned that makes discounting have such a big impact on BCA results sometimes. We all know how the interest costs on a long-term home loan compound such that they eventually become a large share of the total costs paid for the home, and the opportunity cost of capital for a project can be similar.

It means that there are actually three components of a BCA: the benefits, the costs, and the compounded opportunity cost of capital. If the time frame is long enough, that last component can come to dominate the calculations, depending on the discount rate (≈ the interest rate), and that’s what leads to the BCA results that people sometimes object to.

Examples of unpopular results include cases where an environmental project generates large benefits in the distant future (e.g. 100 years), but they count for very little once they are discounted back to the present. For example, with a discount rate of 7% (which was the Australian Government’s recommended rate until recently), $1 million in 100 years is reduced to $1,152 present value. People look at that and think, that’s unreasonable or unwise or unfair, so we should not be discounting the future. Given the way discounting is normally presented and described, their concerns are understandable. But what they are probably missing is that we are not really saying that the benefits should be shrunk by a factor of 868, but rather that the costs should be increased by a factor of 868.

While we can see why people are unhappy with some BCA results, arguing to take discounting out of the process is in reality arguing to ignore one of the costs generated by the project – potentially the largest cost. It wouldn’t occur to people to argue that the up-front costs of a project should be ignored in order to get a more palatable BCA result, but arguing for zero discount rates is actually no more defensible than that.

Currently, we happen to be in a period of exceptionally low interest rates, so the influence of discounting on BCA results is much reduced compared to what it has been for the past 50 years. Some have predicted that low interest rates are here to stay. I’m not prepared to bet, but whatever happens, we need to keep discounting to produce BCA results that genuinely reflect all the benefits and costs to society.

I do acknowledge that there are legitimate concerns about discounting over very long time horizons – e.g., more than 100 years. I talk about those issues in PD34. But in practice, most BCAs consider benefits and costs for around 30 years, and rarely beyond 50. The more challenging conceptual and ethical issues around discounting don’t really kick in on those time scales (see PD224).

Video version of this blog post

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Further reading

Pannell, D.J. (2005). Values in the very long term, Pannell Discussions 34.

Pannell, D.J. (2012). Torturing ourselves over discounting, Pannell Discussions 224.

Pannell, D.J. (2021). BCA criticisms 1: “any result you want”, Pannell Discussions 354.