I have spent my entire life in genetic research, which involves large upfront costs and slow yet permanently accumulating benefits over time. We typically aimed for an IRR in the 20-30% range after inflation adjustment. Of course, part of this was to account for the risk involved. Hence, my surprise when I became involved in genetics to mitigate the impact of global warming led me to Stiglitz and others' 1% discount rates and the implicit "hack" embedded in GWP100. The change Dieter is referring to here will also result in unintended consequences and confusion. In the case of global warming, the usual additional cheat is to also penalise past emissions retrospectively, much like adding a benefit to the analysis of tar sealing the road 20 years ago.
My biggest criticism about the change is that Treasury tried to have it both ways - which will lead to the exact perverse 'usage decisions' that Dieter refers to in the article.
I would have much rather preferred a consistent update to the discount rate - either stick with the conventional wisdom on a 6%, SOC-based rate, or have insisted that everything utilised a 2% SRTP rate. As is, it's now going to be gamed substantially.
Treasury also requires the sensitivity test of the other discount rate, which is just going to confuse Ministers, rather than help them make decisions ("What do you mean the BCR is negative, now?")
That said, it is remarkably difficult to get large scale, intergenerational infrastructure investments to stack up with a 6% discount rate - this was not the only reason, but undoubtedly a contributing factor to our gaping infrastructure deficit.
Excellent article. Hits several nails on the head. I hope the Treasury see this and realize they need to dig deeper. It really feels like they were too flippant in agreeing to lower discount rate for social vs other benefits. It is a minefield for potential perverse outcomes.
The 8% discount rate used by Treasury has been in place since before the 1980s reforms and the significant reduction in inflation since that time.
It leads to perverse outcomes such as pushing chipseal roads, with their reduced service life and expensive ongoing maintenance, rather than asphalt roads which have higher upfront costs but lower maintenance.
A 2% discount rate is far too low considering inflation and long term bond rates available to to the government, however change is required from the 8% rate too.
A brief clarification about inflation: the 2% is in real terms, ie net of general price inflation. In nominal terms it is about 4% (close to the interest rate the government pays on its recent borrowing), given future inflation is expected to be about 2%. Likewise the 8% SOC rate is real, and so it is about 10% nominal.
Hi Alex - the rate that was being utilised prior to this change was 6% - my general view was that 6% was probably in that Goldilocks zone for some - but not all - investments.
In particular, a 6% discount rate very highly punished long-lived (30 year plus) infrastructure investment. I would argue, although I have lots of sympathy for the fiscal reforms of the early 90s, this entire principle of attaching a discount rate close to a commercial rate of return comes from the perspective that government investment must always match (or get pretty darn close) to commercial investment decisions..
With respect, I disagree. There are a large body of government investments which clearly are social goods and the investment shoumd be based on their returns over 30+ years, not 15 (which is effectively what a 6% discount rate will lead you to).
Hi Jason, you are quite correct the rates prior to the most recent changes discussed in the article were 5-6%, refer the below report. They have obviously updated the rates somewhat since I went through uni around 2012.
We cannot however treat money in the future as important as money today. A commercial entity would apply a discount rate as outlined above, and then look for an ROI on top of that. Many government projects, such as motorways and the like, still proceed with a negative ROI after being discounted.
The three main components feeding into discount rates are inflation (and pre 2019 inflation for the last 30 years has been close to 2% on average) so a dollar today is worth more than a dollar in the future; interest costs, as it costs the government money to spend money on this stuff (noting current government 10 year bond rates are 4.5%); and risk, where the government could put its money into something else which could have a higher likelihood of better returns.
Its this final point where the government can choose to increase or decrease its appetite for risk and therefore how to prioritise spending - ie add a lower risk penalty to projects which they want to go ahead. It is a bit of a runaround, ie you could leave the discount rate the same and acknowledge that these projects have higher upfront and NPV costs but have higher intangible returns.
What this does instead is tries to hide the higher costs of these projects behind accounting trickery, which will excite the likes of us reading this article AND commenting on it, but fly over the head of 99% of the population (as it probably should).
What this does instead is tries to hide the higher costs of these projects behind accounting trickery, which will excite the likes of us reading this article AND commenting on it, but fly over the head of 99% of the population (as it probably should).
I have spent my entire life in genetic research, which involves large upfront costs and slow yet permanently accumulating benefits over time. We typically aimed for an IRR in the 20-30% range after inflation adjustment. Of course, part of this was to account for the risk involved. Hence, my surprise when I became involved in genetics to mitigate the impact of global warming led me to Stiglitz and others' 1% discount rates and the implicit "hack" embedded in GWP100. The change Dieter is referring to here will also result in unintended consequences and confusion. In the case of global warming, the usual additional cheat is to also penalise past emissions retrospectively, much like adding a benefit to the analysis of tar sealing the road 20 years ago.
My biggest criticism about the change is that Treasury tried to have it both ways - which will lead to the exact perverse 'usage decisions' that Dieter refers to in the article.
I would have much rather preferred a consistent update to the discount rate - either stick with the conventional wisdom on a 6%, SOC-based rate, or have insisted that everything utilised a 2% SRTP rate. As is, it's now going to be gamed substantially.
Treasury also requires the sensitivity test of the other discount rate, which is just going to confuse Ministers, rather than help them make decisions ("What do you mean the BCR is negative, now?")
That said, it is remarkably difficult to get large scale, intergenerational infrastructure investments to stack up with a 6% discount rate - this was not the only reason, but undoubtedly a contributing factor to our gaping infrastructure deficit.
Dieter, we need you back at the Treasury!
Excellent article. Hits several nails on the head. I hope the Treasury see this and realize they need to dig deeper. It really feels like they were too flippant in agreeing to lower discount rate for social vs other benefits. It is a minefield for potential perverse outcomes.
The 8% discount rate used by Treasury has been in place since before the 1980s reforms and the significant reduction in inflation since that time.
It leads to perverse outcomes such as pushing chipseal roads, with their reduced service life and expensive ongoing maintenance, rather than asphalt roads which have higher upfront costs but lower maintenance.
A 2% discount rate is far too low considering inflation and long term bond rates available to to the government, however change is required from the 8% rate too.
A brief clarification about inflation: the 2% is in real terms, ie net of general price inflation. In nominal terms it is about 4% (close to the interest rate the government pays on its recent borrowing), given future inflation is expected to be about 2%. Likewise the 8% SOC rate is real, and so it is about 10% nominal.
Hi Alex - the rate that was being utilised prior to this change was 6% - my general view was that 6% was probably in that Goldilocks zone for some - but not all - investments.
In particular, a 6% discount rate very highly punished long-lived (30 year plus) infrastructure investment. I would argue, although I have lots of sympathy for the fiscal reforms of the early 90s, this entire principle of attaching a discount rate close to a commercial rate of return comes from the perspective that government investment must always match (or get pretty darn close) to commercial investment decisions..
With respect, I disagree. There are a large body of government investments which clearly are social goods and the investment shoumd be based on their returns over 30+ years, not 15 (which is effectively what a 6% discount rate will lead you to).
Hi Jason, you are quite correct the rates prior to the most recent changes discussed in the article were 5-6%, refer the below report. They have obviously updated the rates somewhat since I went through uni around 2012.
https://www.treasury.govt.nz/publications/commissioned-report/how-should-new-zealand-government-discount-future-payoffs
We cannot however treat money in the future as important as money today. A commercial entity would apply a discount rate as outlined above, and then look for an ROI on top of that. Many government projects, such as motorways and the like, still proceed with a negative ROI after being discounted.
The three main components feeding into discount rates are inflation (and pre 2019 inflation for the last 30 years has been close to 2% on average) so a dollar today is worth more than a dollar in the future; interest costs, as it costs the government money to spend money on this stuff (noting current government 10 year bond rates are 4.5%); and risk, where the government could put its money into something else which could have a higher likelihood of better returns.
Its this final point where the government can choose to increase or decrease its appetite for risk and therefore how to prioritise spending - ie add a lower risk penalty to projects which they want to go ahead. It is a bit of a runaround, ie you could leave the discount rate the same and acknowledge that these projects have higher upfront and NPV costs but have higher intangible returns.
What this does instead is tries to hide the higher costs of these projects behind accounting trickery, which will excite the likes of us reading this article AND commenting on it, but fly over the head of 99% of the population (as it probably should).
What this does instead is tries to hide the higher costs of these projects behind accounting trickery, which will excite the likes of us reading this article AND commenting on it, but fly over the head of 99% of the population (as it probably should).