The Most Critical Variable in Sustainable Development: Discount Rate
- An example of the effect of discount rate is presented by calculating the welfare optimal wind/solar market share.
- Developed nations with a low discount rate show an optimal wind/solar market share of 37%.
- On the other hand, developing nations with high discount rates show an optimal share of only 2%.
- This is tremendously important given that the developing world increasingly dominates global energy system development.
What is the most important element related to sustainable development? I don’t think many people will answer with “the discount rate”, but I genuinely think this is the single most important sustainability consideration. Unfortunately, it is also one of the most poorly understood elements. This article will attempt to rectify matters by delving a little deeper into this critical parameter.
What is the discount rate?
The discount rate is applied to quantify the fact that we value near-term returns more highly than long-term returns. This concept is highly applicable to energy. For example, a rapidly developing nation will value additional electricity production tomorrow much more highly than additional electricity production 10 years from now simply because it needs the electricity tomorrow to continue its economic development.
The discounting principle can be applied both to the benefits and the costs of energy production. Let’s take a closer look at both elements.
As a simple illustration, the discounted quantity of electricity generated by a 1 kW solar installation costing $2000 over a 30 year lifetime with a 15% capacity factor and no degradation is shown below. It is clear that a higher discount rate strongly reduces the net present value of electricity production over the system lifetime. As a result, the levelized cost of capital increases by a factor of 6 as the discount rate increases from 0% to 20%.
The market naturally accounts for the discount rate through the weighted average cost of capital (WACC) of an energy investment. This works almost like a home loan: at a fixed up-front cost, a higher WACC will require larger monthly payments, thus reducing the attractiveness of the investment.
The main factors influencing the WACC are the demand for capital (mostly influenced by the economic growth rate), the investment risk (risky investments must promise higher returns to attract capital), and financial costs (the cost of banking services to facilitate large transactions). Investment capital will therefore be much cheaper in developed markets growing slowly where a favourable policy environment virtually guarantees the expected return on investment. It should be noted that a reduction in WACC due to favourable policy does not imply reduced risk, but rather a shift in risk from investors to the general population.
Given that 86% of primary energy still comes from fossil fuels (BP statistical review), the primary cost of energy is climate change. This cost is likely to become much larger over future decades than it is today. Accurately quantifying the future costs of climate change is impossible, but let’s take an example where climate change costs in a developing country are increasing linearly from $1 billion per year today to $30 billion per year in 3 decades’ time. The graph for the net present value of these costs is shown below:
Because these costs are concentrated in future years, the effect of discounting is much larger than for the benefits (electricity production) example above. Changing the discount rate from 0% to 20% reduces the net present value of the 30-year climate change cost by a factor of 20.
The the degree to which we should discount future climate change costs depends primarily on the economic growth rate and the degree to which near-term economic growth can reduce long-term climate damages.
A rapidly growing economy would discount future climate change damages very strongly. Firstly, faster growth will reduce the cost of climate change relative to the total productive capacity of the economy, enabling the economy to better deal with future climate change costs.
Secondly, an under-developed economy can greatly reduce future impacts of climate change by simply developing its economy. The improved housing conditions, healthcare services, trade connections and access to knowledge and technology that come naturally with economic development also happen to be excellent mitigation tools for climate damages.
Effects of the discount rate
In general, the discount rate (for both benefits and costs) is high in developing nations and low in developed nations. For example, the WACC for renewable energy projects in developed markets with strong technology forcing policies can be very low. For example, Fraunhofer used a WACC of 2.8% and 3.8% for solar and wind power in a 2013 renewable energy technology cost report for Germany, while the WACC for coal and gas plants amounts to 6.9%. In contrast, developing markets feature much higher WACC numbers, generally, in the order of 10%.
The obvious implication of this tendency is that capital-heavy energy technologies are more suited to the developed world than the developing world. This was eloquently quantified in a recent peer reviewed paper that mapped out the welfare optimal share of variable renewables at different WACC levels and CO2 prices. Both gas (limited availability) and nuclear (socio-political issues) were excluded as options.
As shown in the figure above, the welfare optimal share of wind and solar power increases with decreased WACC and increased CO2 prices. It is also clear that the optimial share of wind/solar saturates at very high CO2 prices as CCS takes over because of the sharp fall in value of wind and solar power with increasing market share (described in an earlier article).
Another perspective is provided below, focusing only on the achieved share of wind and solar power. The contour lines represent welfare optimal percentages of wind and solar power at different levels of WACC and CO2 prices.
This figure is highly relevant to the present discussion because it accounts for discounting both the benefits and costs of new energy investments. The benefits are discounted via the WACC and the most important costs are discounted by lowering the CO2 price.
In the simple example presented earlier, the net present value of CO2 costs in a developing nation with a discount rate of 10% should be about 3 times lower than a developed nation with a discount rate of 3%. As an example, a developed nation might have a WACC of 3% and a CO2 price of $60/ton, while a developing nation has a WACC of 10% and a CO2 price of $20/ton (3x less than the developed nation). Under these conditions, the contour plot above puts the welfare optimal market share of wind and solar at 37% in the developed nation and 2% in the developing nation – a massive difference.
The results from this example – 37% wind and solar in a developed nation and only 2% in a developing nation – are intuitively obvious. A poor country must invest in simple energy technology with low up-front costs to fuel economic growth. Low up-front costs of energy infrastructure free up more surplus capacity to build the things the people really want such as decent housing, schools, hospitals, roads, business districts and factories, all of which have additional knock-on effects on economic development.
In addition to the direct benefits of such economic development, it also reduces the future climate change costs. Climate costs are reduced relatively by growing the productive capacity of the economy and absolutely by fortifying the economy against the most direct climate change damages.
On the other hand, a developed economy does not need to grow its energy supply. Fossil fuels have already been exploited to build the required infrastructure for successful modern living. In addition, the size and the resilience of the economy against climate change will not be much improved when climate change impacts eventually become highly significant. For this reason, clean energy technologies with high up-front, but low running costs should be preferred.