Reflections on What Financial Economics Can and Cannot Teach Us about the Social Discount Rate

Abstract

The principles of financial economics provide equally important insights into the optimal choice of discount rates for both public and private sector decision-makers. However, most governments largely ignore those principles, taking their cost of capital for most purposes as their borrowing rate. This article reviews the arguments often made in support of status quo discounting practices, along with the counterarguments to them. Governments have a choice between several methodologies for risk adjustment, and the practical and conceptual reasons that favor a fair value approach are recapped. The limitations of a financial economics approach become apparent for decisions involving very long time horizons, such as for climate policies. For policies with long-term impacts, intergenerational concerns become paramount, projections of cash flows and discount rates become highly uncertain, and present value calculations are an intrinsically unreliable measure of value. No approach to discount rate selection can overcome those problems; alternative decision criteria need to be established. However, most government investments involve much shorter horizons, and the adoption of standard approaches to risk adjustment could significantly improve social welfare.