The Problem with Discount Rates

Most discount rates used in the green energy space are not calculated rigorously. That must change if we are to truly understand the value of various energy investments. Ultimately we need to develop dynamic cost-benefit models that allow for a varying cost of capital.

Most forms of cost/benefit analysis, valuation, etc. use a discount rate. Net Present Value models, Adjusted Present Value, and Real Options are a few examples. The discount rate reflects a fundamental principle in economics and finance: the time value of money. In a cost-benefit analysis, the discount rate is meant to reflect the cost of capital for the project being evaluated. It is also a measure of expected risk: the higher the risk of the project, the higher the discount rate.

The problem with discount rates is that all cost-benefit models of alternative energy or energy efficiency investments are extremely sensitive to the discount rate. I do mean extremely. I built a model for evaluating solar PV installations which include as variables: the price of electricity, the price of carbon offsets, the price of Renewable Energy Certificates, the annual solar resource (Texas has more than Oregon), and several other things.

In that model, changing the discount rate from 6% to 7% had roughly the same impact as moving the installation from Arizona to Michigan. In fact, variations in the discount rate had a greater impact than any other variable in the model.

Discount rates seem arbitrary, but they are not. Discount rates in these models are based on things like interest rates, which change frequently. Discount rates vary, but that reflects reality: interest rates change.

Discount rates are not a priority. Because calculating them is incredibly complex, analysts often choose them arbitrarily. I have seen many, many reports that used a 10% discount rate, because it is a round number that will not raise eyebrows: it is not particularly high or low.

We should take the discount rate more seriously in the green energy space. Since the discount rate has a disproportionate impact on the models in our industry, as much work should be put into calculating a reasonable discount rate as is put into calculating the energy savings from an efficiency project or the generation projections for a wind turbine.

The bad news is that the standard models for doing this are not particularly helpful for green energy projects (this is particularly true of the Capital Asset Pricing Model). The good news is that the more rigorous calculations of discount rates for clean energy and efficiency projects are generally lower than more arbitrary rates.

I will go into more detail on this subject in the future, but static models probably cannot deal with the problem. We need dynamic models that include probabilities and simulation.