Selecting a Discount Rate for Evaluating Water Distribution Projects — The Sustainability Controversy

Abstract

Water distribution systems produce greenhouse gases during the manufacture, transport and installation of pipes and also particularly as a result of pumping when electricity is derived from the burning of fossil fuels. Typically in a life cycle analysis for the planning of new water distribution system infrastructure, that involves pumping, a present value analysis is carried out to convert annual operating costs for pumping into their present values. The way in which time preferences are incorporated into the calculations strongly affects the outcomes in terms of both costs and associated greenhouse gases. Many water utilities around the world use a discount rate equal to the interest rate or the current cost of capital of between 6 and 8%. Over the last 5 years or so the United Kingdom has been using a discount rate for evaluating projects of 3.5% and declining to 1% between 30 and 301 years. The Stern Review: The Economics of Climate Change has recently recommended that a very low discount rate of 1.4% be used for evaluating projects that lead to the production of greenhouse gases. The Stern Review predicts that dire consequences will occur if the concentration of CO2-equivelent greenhouse gases in the atmosphere exceeds 550 ppm and recommends that immediate drastic and decisive action be taken to progressively cut emissions by 3% per annum over the next century. This paper explores the different options for discount rates proposed for present value analysis by various economists and also considers the arguments for and against using the standard 6 to 8% or a significantly lower or a time declining discount rate that is based on societal preferences. The implications on the design of water distribution systems are assessed.

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