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The Role of the Discount Rate in Cost–Benefit Analysis Between Theory and Practice: A Comparative Survey

Published online by Cambridge University Press:  20 January 2017

Felice Simonelli
Felice Simonelli*
Affiliation:
Law and Economics at LUISS “Guido Carli” University (Rome)
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Abstract

This study focuses on the role of the discount rate in cost–benefit analysis (CBA) of regulation, providing a systematic investigation into regulatory practice vis–à–vis the existing economic theories. In the first part, a quick survey of the main economic literature on the social discount rate (SDR) is presented. In the second part, the current institutional practice is investigated, firstly comparing the recommendations on discounting issued by institutional actors in the US (Office of Management Budget, Environmental Protection Agency) and the EU (Commission), and secondly examining the SDRs adopted in two samples of CBAs selected among Regulatory Impact Analyses of US EPA and Impact Assessments of EU Directorate–General for the Environment. A gap exists between economic theory and institutional practice in the selection of the SDR. Regulatory decisions which are based on CBA reflect the most workable economic literature on discounting rather than the most theoretically consistent one, thus yielding less reliable and less robust results. Scholars who aim at improving the quality of rule–making and at fostering the application of CBA in regulatory decisions should improve the “operational validity” of their research, thus providing practitioners with methods that are both consistent and workable.

Type
Articles
Information
European Journal of Risk Regulation , Volume 4 , Issue 1 , March 2013 , pp. 59 - 71
Copyright
Copyright © Cambridge University Press 2013

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References

1 For the role of CBA in the current institutional framework see: for US, Improving Regulation and Regulatory Review, Executive Order 13563, Presidential Documents, Federal Register, Vol. 76, at p. 3821; for EU, Smart Regulation in the European Union, COM(2010)543. Several alternative evaluation methods are currently used in regulatory impact assessments, but CBA is the only integrated approach capable of measuring the overall impact of a regulation (Jacobs, Scott H., “Current Trends in the Process and Methods of Regulatory Impact Assessment: Mainstreaming RIA into Policy Processes”, in Kirkpatrick, Colin and Parker, David (eds), Regulatory Impact Assessment, Towards Better Regulation? (Northampton, MA: Edward Elgar Publishing, 2007), pp. 17 et sqq.Google Scholar

2 Fraiberg, Jeremy D. and Trebilcock, Michael J., “Risk Regulation: Technocratic and Democratic Tools for Regulatory Reform”, 43 McGill Law Journal (1998), pp. 835 et sqq., at pp. 857 et sqq.;Google Scholar Arcuri, Alessandra, “Risk regulation”, Pacces, Alessio M. , Van den Bergh, Anne M., and Van den Bergh, Roger J. (eds), Encyclopedia of Law and Economics, Second Edition: Regulation and Economics, (Cheltenham: Edwar Elgar Publishing, 2012), pp. 303 et sqq., at. pp. 310 et sqq., also available on ther Internet at ssrn: <Google Scholar http://ssrn.com/abstract=1931592< (last accessed on 04 January 2013).

3 Fraiber and Trebilcock, “Risk Regulation”, supra note 2, at p. 867; Arcuri, “Risk Regulation”, supra note 2, at p. 322.

4 Zhuang, Juzhong, Liang, Zhihong, Lin, Tun, and Guzman, Franklin De, “Theory and Practice in the Choice of Social Discount Rate for Cost–benefit Analysis: A Survey”, 94 ERD Working Paper (Manila: Asian Developing Bank, 2007).Google Scholar

5 OECD, “Methodological Frameworks for Regulatory Impact Analysis: Valuation, Risk and Benefit–Cost Analysis”, in Regulatory Impact Analysis: A Tool for Policy Coherence, (Paris: OECD Publications, 2009), pp. 63 et sqq, at pp. 83 et sqq.Google Scholar

6 The US gross domestic product (GDP) in 2010 was US$12,813 billion, while the EU–27 GDP in the same year was US$13,553 billion (data OECD.stat: constant prices, constant PPPS, OECD base year).

7 For an extensive discussion on the CBA institutionalization process see: for US, John F. Morral III, “An Assessment of the US Regulatory Impact Analysis Program”, in Regulatory Impact Analysis, Best Practices in OECD Countries (Paris: OECD Publications, 1997), pp. 71 et sqq.; and for EU, Andrea Renda, “Law and Economics in the RIA World” (Ph.D. thesis for the European Doctorate in Law and Economics on file at the Erasmus University of Rotterdam, 2011), at pp. 46 et sqq.

8 For an extensive discussion on the issue see Lind, Robert C., “A Primer on the Major Issues Relating to the Discount Rate for Evaluating National Energy Options”, in Lind, Robert C. (ed.), Discounting for Time and Risk in Energy Policy, (Washington DC: Resources For the Future Press, 1982), p. 21 et sqq. Google Scholar

9 Nas, Tevfil F., Cost–Benefit Analysis, theory and application, (Thousands Oaks, CA: Sage Publications, 1996), at p. 131 et sqq.Google Scholar

10 Sunstein, Cass R. and Rowell, Andren, “Intergenerational Equity and Discounting: On Discounting Regulatory Benefits: Risk, Money, and Intergenerational Equity”, 74 University of Chicago Law Review (2007), pp. 171 et sqq.Google Scholar

11 This problem should affect, ex ante, the monetization of future benefits and costs which may actually be underestimated by analysts.

12 Eric A. Posner ,”Agencies Should Ignore Distant–Future Generations”,74 University of Chicago Law Review (2007), pp. 139 et sqq.

13 Sen, Amartya, “Approaches to the Choice of Discount Rate for Social Benefit–Cost Analysis”, in Lind, Robert C. (ed.), Discounting for time and risk in energy policy (Washington DC: Resources For the Future Press, 1982), pp. 110 et sqq.Google Scholar

14 Revesz, Richard L. and Livermore, Michael A., Retaking Rationality – How Cost–Benefit Analysis Can Better Protect the Environment and Our Hearth (New York: Oxford University press, 2008), fallacy 6, pp. 107 et sqq.Google Scholar

15 The adoption of a too–high discount rate results in penalizing projects which involve long–run benefits (dams, highways, environmental regulations, and so on) and in favoring projects which involve long–run costs (nuclear plants, toxic wastes, and so on).

16 Pearce, David, Atkinson, Giles, and Mourato, Susana, Cost–Benefit Analysis and the Environment, Recent Developments (Paris: OECD Publications, 2006), chapter 13, pp. 183 et sqq.Google Scholar

17 Exponential discounting based on a constant and positive discount rate is an axiom not empirically verified ( Samuelson, Paul A., “A Note on Measurement of Utility”, 4 The Review of Economic Studies (1937), pp. 155 et sqq. CrossRefGoogle Scholar).

18 Nas, Cost–Benefit Analysis, supra note 9, at p. 127 et sqq.

19 A partial sensitivity analysis is applied only to the variables or parameters that analysts consider the most significant for CBA.

20 Pearce, Atkinson and Mourato, Cost–Benefit Analysis and the Environment, supra note 16, at. p. 61.

21 Circular A-94 of the Office of Management and Budget, Guidelines and Discount Rates for Benefit–Cost Analysis of Federal Programs, 29 October 1992.

22 Circular A-94 (supra note 21) specifically applies also to RIA.

23 The previous discount rate, suggested in Circular A-94 (supra note 21) issued on 27 March 1972, was equal to 10 %.

24 Circular A-94 (supra note 21), at p. 9. This rate can be considered an estimation of the SMRRPI (see Table 2.1, supra).

25 Ibid., at p. 9. For instance, the use of a higher discount rate is required to evaluate regulatory proposals whose primary cost is to diminish business investments.

26 Circular A-4 of the Office of Management and Budget, Regulatory Analysis, 17 September 2003.

27 This circular took effect in January 2004 for proposed rules and in January 2005 for final rules.

28 Circular A-4 (supra note 26), at p. 32.

29 Ibid., at p. 33.

30 This is the SMRRPI approach (see Table 2.1, supra).

31 This is the SMRTP approach (see Table 2.1, supra).

32 Using the same positive discount rate across generations is explicitly considered attractive from an ethical standpoint.

33 EPA, “Guidelines for Preparing Economic Analyses, National Center for Environmental Economics, Office of Policy”, US Environmental Protection Agency (2010), available on the Internet at: <http://yosemite.epa.gov/ee/epa/eed.nsf/pages/Guidelines.html/$file/Guidelines.pdf> (last accessed on 04 January 2013).

34 In the guidelines of 2000 (EPA, “Guidelines for Preparing Economic Analyses, Office of the Administrator, US Environmental Protection Agency (2000), available on the Internet at: <http://yosemite.epa.gov/ee/epa/eerm.nsf/vwAN/EE-0228C-07.pdf/$file/EE-0228C-07.pdf> (last accessed on 04 January 2013) for the intragenerational discounting, the EPA recommended using both a discount rate from 2 % to 3 % and the 7 % suggested by OMB, adding a display of the future streams of benefits and costs without computing the NPV, and other sensitivity analyses with a discount rate between 2 % and 7 %; for intergenerational discounting, an additional sensitivity analysis with a discount rate between 1.5 % and 3 % was required. In the previous reference document of the EPA (EPA, “Guidelines for Performing Regulatory Impact Analysis”, US Environmental Protection Agency (1983, Reprinted in March, 1991), available on the Internet at: <http://yosemite1.epa.gov/ee/epa/eerm.nsf/vwAN/EE-0228A-1.pdf/$file/EE-0228A-1.pdf> (last accessed on 04 January 2013) a two-stage procedure was suggested. In the first stage, the cost of capital had to be annualized over the lifetime of the project using the SMRRPI (10 %); in the second stage, the streams of benefits and costs had to be discounted using the SMRTP (3 %).

35 EPA “Guidelines 2010”, supra note 33, at p. 1–1.

36 This is the SMRTP (see Table 2.1, supra). EPA suggests estimating this rate with the long–term after–tax and after–inflation returns on savings instruments. An alternative estimation could be provided using the OGR approach (see Table 2.1, supra). The value of this rate should be included between 2 % and 4 %.

37 This is the SMRRPI (see Table 2.1, supra). EPA suggests estimating this rate with the pre–tax marginal rate of return on private investment. The value of this rate should be included between 4.5 % and 7 %.

38 EPA “Guidelines 2010”, supra note 33, at p. 6–10, 6–11.

39 In this approach the selection of the time horizon when the discount rate should decline is left to analysts.

40 This approach leads to the adoption of a lower discount rate; uncertainty does not refer to future benefits and costs included in the analysis, but to economic growth and to expected discount rates.

41 EPA “Guidelines 2010”, supra note 33, at p. 6–22.

42 Ibid., at p. 6–23.

43 EC, “Impact Assessment Guidelines”, 15 January 2009, European Commission (2009), available on the Internet at: <http://ec.europa.eu/governance/impact/commission_guidelines/docs/iag_2009_en.pdf> (last accessed on 04 January 2013).

44 Ibid.

45 EC, “Part III: Annexes to Impact Assessment Guidelines”, European Commission 15 January 2009, available on the Internet at: <http://ec.europa.eu/governance/impact/commission_guidelines/docs/iag_2009_annex_en.pdf> (last accessed on 04 January 2013); the Annex 11.6 is the verbatim copy of the Annex 12 of the previous guidelines (EC, “Annexes to Impact Assessment Guidelines”, European Commission, 15 June 2005, updated on 15 March 2006, available on the Internet at: <http://legislationline.org/download/action/download/id/2235/file/EU_Annexes_Impact_AssessmentGuidelines_2005am2006.pdf> (last accessed on 04 January 2013).

46 Ibid., at p. 71. This rate, according to the suggestions of Nas (Nas, Cost-Benefit Analysis, supra note 9, at p. 142) and Boardman et al. (Antonhy E. Boardman, David H. Greeberg, Aidan R. Vining, and David L. Weimer, Cost-Benefit Analysis, Concept and Practice (Upper Saddle River, NJ: Pearson Education, 2006), at p. 251), can be considered an SMRTP (see Table 2.1, supra).

47 Ibid., at p. 71.

48 Ibid., at p. 71.

49 Environmental policies have been selected because it is more likely that they involve long–term effects and intergenerational issues.

50 This period has been selected because Circular A-4 (supra note 26) of the OMB took effect in January 2005, while the first EC “Annexes to Guidelines 2005” (supra note 45), which provided the same recommendations on discounting as the current EC “Annexes to Guidelines 2009” (supra note 45), took effect in June 2005.

51 OIRA (OIRA, “Report to Congress on the Costs and Benefits of Federal Regulations and Unfunded Mandates on State, Local, and Tribal Entities”, Office of Management and Budget, Office of Information and Regulatory Affairs (2006, 2007, 2008, 2009, 2010, 2011), available on the Internet at: <http://www.whitehouse.gov/omb/inforeg_regpol_reports_congress> (last accessed on 04 January 2013).

52 The definition of “major rule” which requires congressional review is provided in Subtitle E of the Small Business Regulatory Enforcement Fairness Act of 1996: “(A) an annual effect on the economy of $100,000,000 or more; (B) a major increase in costs or prices for consumers, individual industries, Federal, State, or local government agencies, or geographic regions; or (C) significant adverse effects on competition, employment, investment, productivity, innovation, or on the ability of United States-based enterprises to compete with foreign–based enterprises in domestic and export markets” (see <http://archive.sba.gov/advo/laws/sbrefa.html> last accessed on 4 January 2013).

53 OIRA “Report to Congress”, supra note 51.

54 Regulations.gov is the official online source for US government regulations from 300 federal agencies, thus improving the access of US citizens to and their participation in the federal regulatory process (web–site last accessed on 4 January 2013).

55 In order to have an objective selection criterion, the computation of NBs is assumed to be a proxy of the application of the CBA method. Actually EPA RIAs are not always as well–structured as a comprehensive CBA should be.

56 “Final Impact Assessment Reports” at <http://ec.europa.eu/governance/impact/ia_carried_out/cia_2011_en.htm> (last accessed on 04 January 2013) is the official source of EC IA reports that are published online after the EC adopts the corresponding proposal.

57 See note 55, supra. The NBs proxy in the EU is weaker than in the US because NBs in DG ENV IAs are not often the result of a genuine CBA.

58 Thomas, Kenneth W. and Tymon, Walter G. Jr., “Necessary Properties of Relevant Research: Lesson from Recent Criticisms of the Organizational Sciences”, 7 Academy of Management Review (1982), pp. 345 et sqq., at p. 348.Google Scholar