Appendix E.2

DISCOUNTING

The benefits received by the public or by an individual from government and private expenditures often are experienced at approximately the same time that the costs are incurred. This, however, is not always true. In the case of the Environmental Management program, 90 percent of costs will be incurred over the next 45 years; however, many of the benefits will be experienced far after this period. Therefore, in programs such as the Environmental Management program, the time at which benefits and costs are experienced becomes an important consideration.

For example, a dollar spent in ten years is worth less than a dollar spent today because today's dollar could be invested in a savings account or another investment and be worth more than a dollar in ten years. For this reason, policy analysts "discount" future costs and benefits so that all costs and benefits are evaluated at their worth in terms of today's dollars. Intuitively, "discounting" implies that future costs and benefits are worth less than costs and benefits received today. To determine how much less future costs and benefits are worth, analysts typically apply a discount rate. For example, a five percent discount rate implies that $1.05 received in one year is worth a dollar today.

CHOOSING A DISCOUNT RATE

A major issue in discounting future costs and benefits is selecting the appropriate discount rate. This choice often has a major effect on policy analysis results (as discussed in the next section). Analysts emphasize the use of two major variables to determine the proper discount rate. The first variable is the rate at which people are willing to sacrifice present consumption for future consumption. This is often called the time preference rate or the social rate of time preference. Second, public projects use resources that can be employed in private investment projects. Thus, if private investment projects yield 15 percent, diverting resources from private investment to public projects entails an opportunity cost of 15 percent or an opportunity cost rate of 15 percent. The return on private investment is often called the opportunity cost rate. The discount rate is usually approximated as one of these two rates. Using an appropriate discount rate, policy analysts can calculate the "present value"of streams of costs and benefits.

Based on analysis of the social rate of time preference and the opportunity cost rate, the U.S. Environmental Protection Agency and the Office of Management and Budget suggest using real discount rates (above inflation) of approximately three percent to seven percent.

EFFECT OF DISCOUNTING ON BASE CASE AND ALTERNATIVE CASE COST ESTIMATES

Table E.1 displays life-cycle costs in constant 1996 dollars and present value costs for the Base Case and nine alternative cases. The present value cost for each case was calculated separately using a three percent and a seven percent discount rate. Table E.1 also ranks the cases from least expensive (1) to most expensive (10). As is evident from this presentation, discounting results in a different relative ranking of the cases based upon cost. This is most evident in the funding reduction case. In constant 1996 dollars, the funding reduction case is the second most expensive case. In contrast, the present value cost of the funding reduction case is the second least costly alternative. The major reason for this difference is that the funding reduction case shifts costs farther into the future. Shifting costs farther into the future translates into a lower present value. To a lesser extent, costs for the delaying waste disposal case are higher than those for the Base Case in constant 1996 dollars, but have a lower present value cost than the Base Case. Discounting has little effect on the relative cost ranking of the other cases because the time profile of costs is similar for these cases.

Chapter -1- / -2- / -3- / -4- / -5- / -6- / -7- / -8-

Appendix -A2- / -B- / -C- / -D- / -E1- / -E2- / -F- / -G- / -H- / Glossary