Russian aggression and the climate emergency are among the urgent challenges facing Europe today. An effective response will require massive, long-term investments in energy infrastructure. In a new paper, TSE’s Frédéric Cherbonnier and Christian Gollier argue that such initiatives must adopt a risk-adjusted discount rate to ensure value for money. They show how to estimate this rate for public and private projects, with applications to the electricity sector.
Why is discounting crucial to investing wisely, especially in the green transition?
Given opportunity costs, €1 today is worth more than €1 tomorrow. Discounting is a controversial but essential tool that helps us to evaluate investments by putting a price on tomorrow’s cash flows. By penalizing delayed returns and risky projects, it helps to encourage more efficient investments.
The use of risk-adjusted discount rates is much less prevalent in the public sector, probably due to difficulties in measuring social impacts. Most governments use a simplified system with a single discount rate unconnected to the investment’s risk. This is likely to yield an inefficient allocation of capital in the economy, leading to under-investment in safe projects and over-investment in riskier ones. For example, the under-investment highlighted by the Covid crisis in certain areas (e.g. medical equipment, masks, etc.) is partly attributable to insufficient valuation by the public authorities of projects that provide protection against certain risks.
Decarbonization requires huge investments in the energy sector that are shrouded in deep uncertainties. These range from the evolution of energy demand and carbon price, to the development of network infrastructure and technologies for CO2 capture, electricity storage, and biofuels. Given the long duration of such investments, discounting must play a key role in the decision process, improving allocation of capital, and the speed and efficiency of the energy transition.
How have ideas about the social discount rate evolved?
For decades, public institutions used the Arrow-Lind theorem (1970) to support the use of a single discount rate to evaluate their investments. The idea was that the mutualization capability of the public sector is so large that the risks of individual projects are washed out by diversification. In reality, some public projects magnify the aggregate risk, whereas others hedge it. Confronted by huge uncertainties about the future, ignoring the role of public actions in managing them is a big mistake.
The right reaction was provided by the Consumption-based Capital Asset Pricing Model (CCAPM). This supports a discounting system with three ingredients: A "risk-free" discount rate for projects whose net benefits are independent from aggregate consumption, a systematic risk premium, and a CCAPM cash-flow beta. The beta is specific to the project, and, potentially, to the maturity of the benefit. It is defined as the elasticity of the project’s net social benefit to a change in aggregate consumption. A positive beta means a larger discount rate should be used to penalize the project for being risky; a negative beta signals a project should earn a reduced rate because it insures against macroeconomic risk.
Existing research has mostly focused on which risk-free rate and systematic risk premium should be used. Very little progress has been made regarding project-specific betas, which is the focus of our paper.
What was the inspiration for your research?
There is an emerging consensus among researchers on the risk-free rate and, in particular, on the need for declining discounting rates for risk-free projects. We attempt to develop this consensus and to convince public decision-makers to adopt better discounting rules. While our project is not related to the energy sector specifically, it was triggered by concerns in the French electricity sector about the lack of clear guidelines on discount rates for public evaluators.
How do you encourage use of a risk-adjusted discount rate?
Our paper refines the methodology for estimating project-specific betas, taking into account the economic characteristics of supply and demand. We first provide an explicit formula for the risk-adjustment beta based on the elasticity of supply and demand (with respect to price and income) for the goods or services generated by the investment. In particular, we develop the intuitive link between the beta and income-elasticity of demand: the beta is positive for a superior good, and negative for an inferior good. This leaves evaluators with the easier task of estimating price and income elasticities.
The elasticity of supply also affects the beta of the underlying asset. To examine this, we consider a more specific class of investments in core infrastructure including transport or electricity networks. Here, we find that social betas vary greatly depending on the time horizon. When there is limited capacity, the beta has a decreasing term structure with surprisingly large value at short maturities, when capacity is under-utilized. Besides, when infrastructure is used for exporting goods and services, the beta can be negative for the country that uses this link mainly to export. This is due to the fact that the demand for electricity will be reduced in a recession, thereby rendering the connection even more useful to export its excess electricity.
Importantly, we carry out an estimation on the France-Spain electric cross-border link that provides, to our knowledge, the first real-case based example of a negative beta. Our results show that risk adjustment of the social beta can radically alter capital allocation in the public sector.
How might this promote more efficient use of public resources?
We help decision-makers to identify the investments that provide some form of insurance for our economies. Investments in core infrastructure such as transportation and public utilities can have a strong and positive impact on private output. Institutions in charge of those infrastructures must constantly anticipate the growth in demand. They must allocate investments accordingly between maintenance, renewal and extension of their networks. The decreasing term structure highlighted in our work can play a crucial role in determining the optimal timing of an increase in the size of such infrastructures.
Our concrete example of investment in France-Spain electricity connections is particularly significant as it concerns countries belonging to the Eurozone. This incomplete monetary union suffers significant asymmetric shocks that cannot be mitigated by traditional adjustment mechanisms via labor mobility. Our research shows that project-specific betas are a valuable means of prioritizing investments to attenuate the adverse impacts of such shocks.
Article published in TSE Reflect, May 2022