Do we need an appropriate social discount rate for transformative infrastructure projects?
The decision to execute a project depends on net profitability or cost-benefit ratio of the project, which depends on how the future benefits are valued. Discount rate is a key input in project viability and execution decisions and are used to determine the value of future benefits today. Higher discount rates imply lower value of future benefits today.
The market interest rate is often used as a discount rate within the corporate sector. But the infrastructure sector involves social projects which present distortions, uncertainties and externalitiesthat prevent the private rate from representing how social projects will impact others. For this reason, there is a need to estimate a social discount rate (SDR), especially when considering infrastructure projects whose long-term benefits will ensure efficient allocation of resources and intergenerational equity.
What should be the appropriate rate when evaluating infrastructure projects by public authorities and development banks, given the importance of SDR for policy-making? Transformative infrastructure projects have large economic, social and environmental (ESE) impacts which are not fully captured quantitatively in cost-benefits estimation due to the lack of data, methodologies or capacity. In addition, the long life of infrastructure investments makes their value highly sensitive to discount rates.
Literature about how much the SDR should be is scarce. In a 2015 from the Inter-American Development Bank, the SDRs used vary widely between developed and developing countries ranging between 3-7% and 8-15% respectively but these rates may have reduced in the last years. International institutions particularly multilateral development banks typically recommend a discount rate in the range of 10-12%.
To assist with this topic, the GIobal Infrastructure Hub developed a Cost-Benefit Analysis of Transit Investments Tool that enables governments and project proponents to define and articulate the ESE benefits more quickly, in a much more accessible and affordable manner than a typical complex and time-consuming cost-benefit analysis. The online tool allows users to input a SDR of their choice to estimate today’s value of future benefits and strengthen the cost-benefit analysis. View further details on metrics estimated by the Tool, here and download the Tool here.