Julia Raybould: What effect does Sustainability have on a Discount Rate?

Today Julia Raybould, who has been working tirelessly with the Sustainability Team to help us gain our ISO14001 accreditation for our sustainability management system takes over the blog and gives us an insight into how sustainability relates to economics. Here she focusses on the discount rate, an element from her masters dissertation she did for her MPhil in Environmental Policy at Cambridge.

Julia is leaving the Sustainability Team today and heading for Her Majesty’s Revenue and Customs but in the few months she has been working with us in the Sustainability Team she has been a driving force in getting our sustainability management system up to ISO14001 standards. We wish her the best of luck in her new role and HMRC can be rest assured they are getting an absolute gem!

Sustainable Economics

Sustainability is said to stand on three pillars – environment, society and economics. The Economics Pillar is often forgotten or is only discussed in the context of cost savings. But, as the economy and economic growth features more in the media and society is scrambling to find solutions to debt and growth on a finite planet, the economic pillar is coming into its own. Think tanks such as the New Economics Foundation and RESOLVE are considering alternative solutions to creating a sustainable economy.

One area where economics and sustainability overlap is in the appraisal of potential sustainability projects – whether this is the purchase of renewable energy technologies or investing in biodiversity initiatives.

The all important discount rate

A critical decision in most financial appraisals is the choice of the discount rate, because this little number has a huge impact on whether long term costs and benefits are considered important. Because of its importance, the ‘correct’ value for a discount rate has been a controversial issue for most of the 20^th Century.

But what is a discount rate? It is a value multiplied to the costs and benefits at each period in time over the project’s duration. This enables future and present values to be compared. For example, one pound discounted at a rate of 3.5% in 30 years has a net present value of £0.36 today. Thus, very quickly future benefits can become negligible when high discount rates are used.

On the whole, a high discount rate favours projects with immediate or short returns on investment. Any project with a medium- or long-term payback is shown in an unfavourable light. As environmental investments often have high upfront costs with paybacks over long periods of time, when combined with a high discount rate, these projects will appear financially unsound. However, this is not necessarily the case. If a lower discount rate had been chosen, the same project may appear to be a great investment.

If the discount rate is so influential and yet so subjective, shouldn’t more people consider it when making investment decisions??

In the last ten years, the UK government has stepped up to the challenge. The HM Treasury guidance now requires much lower discount rates to be used for long-term project appraisals.

More dramatically, the Stern Review’s Economics of Climate Change argued that due to climate change’s unique characteristics – impacts that last hundreds of years and potentially causing large-scale damage for future generations – meant that an even lower discount rate, close to zero should be used.

Since the Stern Review, HM Treasury has released additional guidance stating that in the evaluation of projects that will involve “substantial and, for all practical purposes, irreversible wealth transfers between generations” and are very long term (in excess of 50 years) a much lower discount rate is advocated (HM Treasury 2008, p.4). This acknowledges that some projects will impact upon the very wellbeing of future generations and the discount rate should reflect this.

How does this affect you?

When considering future environmental projects at your organisation, it is worth questioning the discount rate used, specifically:

• For any project with a lifetime greater than 30 years, the argument can be made to use a low discount rate.
• For very long term projects, e.g. climate change mitigation and adaptation, biodiversity or ecosystem services, a discount rate close to zero matches the UK government’s approach.
• Finally, it is fair to request a sensitivity analysis of the discount rate be completed for all sustainability investment appraisals. This means that the same analysis is undertaken using different discount rates (low and high). Vastly different results will demonstrate that further deliberation is needed regarding the most appropriate value for the discount rate.

For further information on the government guidance discussed, see HM Treasury’s website: http://www.hm-treasury.gov.uk/green_book_guidance_discounting.htm