Choice of discount rate in World Bank Transport Projects

1. Choice of discount rate in World Bank Transport Projects Robin Carruthers TUDTR June, 2004

2. What is the function of the discount rate? The discount rate fulfills three functions in a cost benefit analysis and the rate used is usually a compromise between the rates that satisfy each of these needs • To represent the marginal social rate of time preference; • to represent the opportunity cost of capital; • the real cost of foreign borrowing, which ensures that investment funds are committed to projects that will be able to meet the country's debt obligations, especially where investment is highly dependent on inflows of foreign capital; • It is also often used as a minimum acceptable value for projects subject to economic rate of return calculations (since projects with a lower ERR will also have a negative NPV if this same value is used for the discount rate.

3. What is the marginal social rate of time preference • The marginal social rate of time preference (SRTP) is the rate that society is willing to trade present consumption for future consumption. People who are net borrowers have MRTPs greater than the interest rate charged. Technically, the MRTP is equal to the marginal rate of substitution between present and future consumption when it is equal to the rate of return on savings.Economists often use the interest rate on treasury bills as the nominal rate of return on savings. • For example, the nominal yield on April 2004 treasury bills of three-year constant maturity is about 5%. If the expected inflation rate is 1%, the real rate of return is about 4%: • (.05 - .01)/(1+.01) = 3.96%

4. What is the opportunity cost of capital? • The economic cost of capital can be practically measured by the economic opportunity cost of funds drawn from the various sectors of the economy as a result of borrowing from the capital markets to finance investments. When a project uses funds that are raised in the capital markets, interest rates will tend to rise. Because of the higher financing cost, some private businesses will either cut back or postpone their investment plans. On the other hand, private savers will save more because of the opportunity to earn a higher return on their savings. The EOCK can then be estimated as a weighted average of the rate of return on displaced private-sector investment () and the rate of return to private-sector savers (). That is, EOCK = f1  + f2 

5. What discount rates are used in the World Bank • Transport Sector 12% (14% in Peru, 15% in Philippines) • Energy Sector 10% or 12% • Education Sector 10% and cost effectiveness • Environmental Projects None found with economic evaluation • Health Sector 10% (mostly cost effectiveness assessment and few economic evaluations) • PREM 4% (Argentina Documentation System) “Traditionally the World Bank has used 10% to 12% s the discount rate for all Bank-financed projects. This rate is but a rationing device for WB funds and should not be construed to reflect the cost of capital in borrowing countries. Task Managers are free to use higher or lower rates where warranted, as long s they provide a sound justification. A discount rate of less than 10% might be difficult to justify as most research has shown that the cost of capital for developing countries is higher than 10%” Handbook on Economic Analysis of Investment Operations

6. Basis for estimating the discount rate • We often use the expected rate of return on private sector projects as a simple estimate of the discount rate to be used in public sector projects. • What rates of return does the private sector look for in transport investments and what is the basis for those estimates. • At least three differences are allowances for uncertainty, inflation and revaluation of assets.

7. Uncertainty and risk • In public sector economic analyses we tend to minimize the impact of risk, and often use the rate of return on public bonds (a relatively risk free investment) and the source. In contrast, the private sector sees investment in infrastructure as a high risk activity and so looks for a high rate of return. • The estimates that I have been given range upward of 20% for a medium-risk project. Potential investors in a large private sector bridge project said thy would be looking for rates of return in excess of 22% • One interpretation of the financial results of a large international investor in toll roads (Macquarie Infrastructure) shows a rate of return on investment of nearly 30%.

8. Inflation • One main difference between economic and financial analyses is that the former are usually made in constant monetary terms (disregarding inflation) whereas the latter are in current monetary units (taking account of inflation). • We do not include inflation allowances in our economic evaluations, and current rates of inflation are low by the standards of the last twenty years. But an allowance of 3% would reduce the private sector rate of return by the same amount and bring it closer to our 12%

9. Asset values • Private investors typically revalue their assets every year. While this can improve many of their financial indicators, it does not help the rate of return on the value of current assets. In our economic evaluations we typically do not take account of any change in the value of assets, whether due to inflation or market revaluations.

10. ADB method • Despite these problems, the Asian Development Bank provides a method and example of how to calculate the opportunity cost of capital • See http://www.adb.org/Documents/Guidelines/Eco_Analysis/appendix20.asp

12. Impacts of using a high discount rate • There is a tendency to select projects that have short term benefits over those with longer term benefits. This favors: • Marginal additions to existing capacity over building new capacity (roads, ports etc) • Bus systems over metro systems • Gravel roads over paved roads • Staged construction over single stage construction • Diesel over electric rail technology

13. Discount rate as minimum acceptable rate of return • In many projects, we use a minimum cut off rate for consideration of sub-projects. This rate is typically 12%, presumably derived from the discount rate. • By using a different cut-off rate, and a multiple criteria evaluation method, we would include consideration of alternatives that would otherwise be rejected.

14. Suggestion: Use the MERR instead of ERR • Make use of Modified Economic Rate of Return. This allows different discount rates to be used for the opportunity cost of capital and for the users’ time preference rate. • In Excel it is necessary to use both the time stream of investment costs and of gross net benefits (including maintenance and operating costs as well as user and operator benefits) • MIRR = (values, finance rate, reinvest rate) • Values is the range of values for which a Economic Rate of Return is required. Finance rate is the opportunity cost of capital. This is applied to all the input values for capital investment. Reinvest rate is the time preference rate for benefits and is applied to all the flows of benefits less maintenance and operating costs.

15. Suggestion: Short and Long term • In the short term, for projects where there is a choice between short and long term solutions, undertake a sensitivity test on the NPV using 8% (going to 10% makes little difference); • In the longer term, re-open the issue of the discount rate used in World Bank projects • Try to reopen the issue with other sectors in the Bank to regain the consistency we thought we used to have.