But not in the way you’d wanted. You may even wish that you’d never wished at all.
For a long time, government cost-benefit assessment has been criticised for putting too little weight on the future.
Many projects involve up-front spending and, for example, environmental benefits in a few decades’ time.
Conventional approaches make it hard to justify spending a lot of money today for something that only yields benefits in a few decades. I think the conventional approach is the correct one, but we’ll come back to that.
Critics wanted to change how cost-benefit assessment is undertaken so that projects with up-front costs and long-term benefits would have an easier time of things. They were often thinking about environmental initiatives when wishing for a change in how government weighs costs and benefits over time. Or, at least, they were often citing environmental initiatives when making the case.
They made their wish.
A finger on the monkey’s paw curled.
Treasury produced updated guidelines. So did the New Zealand Transport Agency.
Then, a few weeks ago, the government released the investment case summaries for a bundle of new Roads of National Significance (RONS). Roads that likely would not have made the cut under the old conventional model made it through under the new approach.
Isn’t that what everyone wished for?
Let’s first walk through how discount rates work. Then we’ll come back to the changes in government cost-benefit assessment and how a change some hoped would secure environmental benefits wound up helping to justify new roads.
Governments always have to weigh the merits of different policies against each other. No matter how much the government raises in taxes, it will always have to decide which potential next project does not quite make the cut.
Cost-benefit analysis can help or at least can put projects against a common ruler. That does not mean only assessing a project’s financial costs and benefits. Non-financial costs and benefits can also be weighed. They just need to be put into dollar terms. And Treasury provides helpful indicative values for all kinds of less tangible considerations.
Things get a little bit trickier if different projects have benefits and costs over different periods.
Leave aside, for the moment, appropriate cynicism about politicians wanting projects that yield benefits before the next election. If you wanted to make the right decision, how would you do it?
You need some way of putting projects onto a common basis, so that you can usefully compare a project whose benefits turn up in year three (with a few additional costs in year five) with a project that does not show benefits until year five but whose costs are mainly in year two.
It isn’t rocket science, but it does wind up using specialised terms.
Imagine that you had a choice between receiving $100 today or receiving a slightly larger amount at the same time next year – with an inflation adjustment built in. How much more would you have to receive next year to make you just as happy either way?
If you would have to receive $105 (plus compensation for inflation) next year to make you just as happy as getting $100 today, a dollar next year is worth 5% less to you than a dollar today. We call that the discount rate: the rate at which you discount future costs and benefits relative to things that happen this year.
Analysts can use that discount rate to turn future costs and future benefits into their present value today. Those present values provide a fair way of comparing projects against each other.
And here we get to the concern that critics of the approach have had.
If you look far enough into the future, any discount rate that isn’t trivially low winds up looking like it doesn’t care much about the future. At a five percent discount rate, it’s barely worth spending a dollar today to get an inflation-adjusted $150 in a century’s time.
As a report from the Parliamentary Commissioner for the Environment put it,
“While CBAx [Treasury’s cost-benefit spreadsheet] allows analysis using a standard discount rate of five per cent and an alternative rate of two per cent, the official Treasury rate is five per cent. The use of a constant discount rate potentially distorts the appraisal of environmental initiatives whose benefits frequently accrue over longer time frames. Accordingly, applying standard discount rates to proposals that address growing environmental concerns over many years becomes problematic from the standpoint of allocating fiscal resources.”
They urged that the government review cost-benefit processes “to ensure that budget proposals with enduring benefits to future generations are not effectively discounted away to nothing.”
Late last year, Treasury adopted a split discount rate model. Commercial projects would be evaluated against an 8% discount rate. Non-commercial proposals would face a 2% discount rate for their first thirty years, and a 1.5% discount rate for the next seventy years. Benefits and costs after that first hundred years would face a 1% discount rate.
And a mandatory sensitivity test would check what non-commercial projects would look like under an 8% discount rate, and what commercial projects would look like with a 2% discount rate.
Sounds like a win. The paw’s finger curled. We have a new cost-benefit framework that puts much more weight on projects that might provide benefits in the far off future.
But environmental projects are not the only ones that might have large up-front costs and substantial benefits in the far off future.
Other investments are like that too.
Consider, for example, a giant new motorway. Or, perhaps, several of them.
Giant new motorways are very expensive to build – huge up-front costs. But after they’re built, motorists get to enjoy them for decades, so long as they’re maintained.
Under conventional discount rates, benefits to road users after the first couple of decades do not count for very much. But roads are not commercial projects. Would any investor build one if tolls from users had to cover all the costs? It seems unlikely at current construction costs.
So the roads get a 2% discount rate for their first thirty years, and lower discount rates over the next three decades.
Suddenly, benefits from driving on those roads decades from now will count for more than nothing. The present value of those future drivers’ benefits can weigh against the estimated $2.9 to $3.8 billion cost of building a couple of large tunnels and associated improvements to State Highway One in Wellington.
The benefit-cost ratio for the Wellington improvements is 1.2. Every dollar’s worth of cost, in present value terms, brings $1.20 in benefits. It would not take much change to either the benefit side or to the cost side for the ratio to fall to less than one.
NZTA has likely undertaken the mandatory sensitivity tests checking the figures at an 8% discount rate. But if it has published the results, I have been unable to find them. I expect a few projects would have failed under the old conventional approach.
Last April, Treasury’s former guru of cost-benefit analysis, Dieter Katz, warned about Treasury’s new public sector discount rates.
I share Katz’s in-principle objection to the new lower discount rates. Resources invested by government in hope of a 2% return are a waste when higher returns are available elsewhere. But leave that concern aside. Good, competent economists take the other side of this issue. It’s debatable and debated.
The political economy issue is substantial. The monkey-paw wish for low discount rates to put a thumb on the scale for environmental projects turned into a measure that very likely helped get marginal motorways over the line.
Katz warned that the distinction between commercial and social projects would be “muddy”. As he put it, “To illustrate, consider the construction of a new road. The main benefit is usually travel time savings. There is no market for these. Is it therefore a “social” investment?”
The new line between projects earning preferred discount rates and those earning punitive discount rates will likely be redefined with changes in government. The bright line rule is gone, along with the Treasury that was cognizant of this kind of risk.
I hope they all enjoy the new motorways.
Dr Eric Crampton is Chief Economist at the New Zealand Initiative. This article was first published HERE
Many projects involve up-front spending and, for example, environmental benefits in a few decades’ time.
Conventional approaches make it hard to justify spending a lot of money today for something that only yields benefits in a few decades. I think the conventional approach is the correct one, but we’ll come back to that.
Critics wanted to change how cost-benefit assessment is undertaken so that projects with up-front costs and long-term benefits would have an easier time of things. They were often thinking about environmental initiatives when wishing for a change in how government weighs costs and benefits over time. Or, at least, they were often citing environmental initiatives when making the case.
They made their wish.
A finger on the monkey’s paw curled.
Treasury produced updated guidelines. So did the New Zealand Transport Agency.
Then, a few weeks ago, the government released the investment case summaries for a bundle of new Roads of National Significance (RONS). Roads that likely would not have made the cut under the old conventional model made it through under the new approach.
Isn’t that what everyone wished for?
Let’s first walk through how discount rates work. Then we’ll come back to the changes in government cost-benefit assessment and how a change some hoped would secure environmental benefits wound up helping to justify new roads.
Governments always have to weigh the merits of different policies against each other. No matter how much the government raises in taxes, it will always have to decide which potential next project does not quite make the cut.
Cost-benefit analysis can help or at least can put projects against a common ruler. That does not mean only assessing a project’s financial costs and benefits. Non-financial costs and benefits can also be weighed. They just need to be put into dollar terms. And Treasury provides helpful indicative values for all kinds of less tangible considerations.
Things get a little bit trickier if different projects have benefits and costs over different periods.
Leave aside, for the moment, appropriate cynicism about politicians wanting projects that yield benefits before the next election. If you wanted to make the right decision, how would you do it?
You need some way of putting projects onto a common basis, so that you can usefully compare a project whose benefits turn up in year three (with a few additional costs in year five) with a project that does not show benefits until year five but whose costs are mainly in year two.
It isn’t rocket science, but it does wind up using specialised terms.
Imagine that you had a choice between receiving $100 today or receiving a slightly larger amount at the same time next year – with an inflation adjustment built in. How much more would you have to receive next year to make you just as happy either way?
If you would have to receive $105 (plus compensation for inflation) next year to make you just as happy as getting $100 today, a dollar next year is worth 5% less to you than a dollar today. We call that the discount rate: the rate at which you discount future costs and benefits relative to things that happen this year.
Analysts can use that discount rate to turn future costs and future benefits into their present value today. Those present values provide a fair way of comparing projects against each other.
And here we get to the concern that critics of the approach have had.
If you look far enough into the future, any discount rate that isn’t trivially low winds up looking like it doesn’t care much about the future. At a five percent discount rate, it’s barely worth spending a dollar today to get an inflation-adjusted $150 in a century’s time.
As a report from the Parliamentary Commissioner for the Environment put it,
“While CBAx [Treasury’s cost-benefit spreadsheet] allows analysis using a standard discount rate of five per cent and an alternative rate of two per cent, the official Treasury rate is five per cent. The use of a constant discount rate potentially distorts the appraisal of environmental initiatives whose benefits frequently accrue over longer time frames. Accordingly, applying standard discount rates to proposals that address growing environmental concerns over many years becomes problematic from the standpoint of allocating fiscal resources.”
They urged that the government review cost-benefit processes “to ensure that budget proposals with enduring benefits to future generations are not effectively discounted away to nothing.”
Late last year, Treasury adopted a split discount rate model. Commercial projects would be evaluated against an 8% discount rate. Non-commercial proposals would face a 2% discount rate for their first thirty years, and a 1.5% discount rate for the next seventy years. Benefits and costs after that first hundred years would face a 1% discount rate.
And a mandatory sensitivity test would check what non-commercial projects would look like under an 8% discount rate, and what commercial projects would look like with a 2% discount rate.
Sounds like a win. The paw’s finger curled. We have a new cost-benefit framework that puts much more weight on projects that might provide benefits in the far off future.
But environmental projects are not the only ones that might have large up-front costs and substantial benefits in the far off future.
Other investments are like that too.
Consider, for example, a giant new motorway. Or, perhaps, several of them.
Giant new motorways are very expensive to build – huge up-front costs. But after they’re built, motorists get to enjoy them for decades, so long as they’re maintained.
Under conventional discount rates, benefits to road users after the first couple of decades do not count for very much. But roads are not commercial projects. Would any investor build one if tolls from users had to cover all the costs? It seems unlikely at current construction costs.
So the roads get a 2% discount rate for their first thirty years, and lower discount rates over the next three decades.
Suddenly, benefits from driving on those roads decades from now will count for more than nothing. The present value of those future drivers’ benefits can weigh against the estimated $2.9 to $3.8 billion cost of building a couple of large tunnels and associated improvements to State Highway One in Wellington.
The benefit-cost ratio for the Wellington improvements is 1.2. Every dollar’s worth of cost, in present value terms, brings $1.20 in benefits. It would not take much change to either the benefit side or to the cost side for the ratio to fall to less than one.
NZTA has likely undertaken the mandatory sensitivity tests checking the figures at an 8% discount rate. But if it has published the results, I have been unable to find them. I expect a few projects would have failed under the old conventional approach.
Last April, Treasury’s former guru of cost-benefit analysis, Dieter Katz, warned about Treasury’s new public sector discount rates.
I share Katz’s in-principle objection to the new lower discount rates. Resources invested by government in hope of a 2% return are a waste when higher returns are available elsewhere. But leave that concern aside. Good, competent economists take the other side of this issue. It’s debatable and debated.
The political economy issue is substantial. The monkey-paw wish for low discount rates to put a thumb on the scale for environmental projects turned into a measure that very likely helped get marginal motorways over the line.
Katz warned that the distinction between commercial and social projects would be “muddy”. As he put it, “To illustrate, consider the construction of a new road. The main benefit is usually travel time savings. There is no market for these. Is it therefore a “social” investment?”
The new line between projects earning preferred discount rates and those earning punitive discount rates will likely be redefined with changes in government. The bright line rule is gone, along with the Treasury that was cognizant of this kind of risk.
I hope they all enjoy the new motorways.
Dr Eric Crampton is Chief Economist at the New Zealand Initiative. This article was first published HERE
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