Report

Unfreezing discount rates: transport infrastructure for tomorrow

25 Feb 2018
Description

Australian governments can borrow money more cheaply today than at any time in their history. The combination of cheap money and booming population growth has led to regular calls for more investment in transport infrastructure; with money so cheap, it is easier than ever for a project to generate a return that is greater than the cost of borrowing.

And yet Australian governments have been remarkably consistent in sticking with a 7 per cent central ‘discount rate’. Real borrowing rates are one of the key components of the discount rate, yet whether they have been 8 per cent or 1 per cent, government agencies have chosen to keep their discount rates at 7 per cent since at least 1989.

Discounting may seem an arcane idea, but governments must be able to compare one project with another, by putting costs and benefits that occur at different points in time on an equivalent footing.

This report accepts the underlying framework that Australian governments use to rationalise their discount rates, which are supposed to reflect the next-best use of the resources for that project, and with the same level of risk. The next-best project could be in the transport portfolio, in another portfolio, or even a financial investment overseas with the same level of risk.

ut this report does not accept the way this concept is applied: instead of being frozen at 7 per cent, discount rates should vary when there is material variation in the cost of money. In addition, discount rates should differentiate between projects that are more risky and those that are less risky. This report shows that this can be done in a straightforward and practical way.

The type of risk that matters for discounting is the sensitivity of a project’s expected returns to the economy generally – the systematic risk. Most government transport infrastructure is still used whether the economy is booming or in the doldrums, because most people keep on travelling to work or school and buying transported goods. But some projects are more sensitive than others to the state of the economy, and the discount rate should be higher for them.

The cost of money is usually inferred from government borrowing costs, signalled by the 10-year Commonwealth bond rate. Back in 1989, when it seems that the 7 per cent discount rate was established in Australia, the risk-free rate was 6.8 per cent in real terms; in 2017, it was 0.8 per cent. Discount rates should reflect such a dramatic change.

Incorporating risk and the cost of low-risk borrowing would lead to discount rates in 2018 of around 3.5 per cent for projects where systematic risk is low, and around 5 per cent where it is high by the standards of transport infrastructure projects. Both rates are substantially below today’s 7 per cent standard central rate.

Lower discount rates will help to make clear which are the most valuable transport projects available. But they will also make the economics of all transport projects look better.

It may seem that in a world where politicians are too often tempted to waste public money, a high discount rate could serve as a useful counter-balance. But this comes at a cost. It distorts public policy priorities too much away from longer term projects. And it may well dissuade those involved in project evaluations from insisting on rigorous analysis elsewhere in transport project business cases.

Australia should bring longer-term projects back into the frame. And it should set the bar higher for project assessment. Better discounting would be a big step in that direction.

Publication Details
Identifiers: 
ISBN: 
978-0-6482307-3-1
Language: 
License Type: 
CC BY-NC-SA
Published year only: 
2018
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