4.3.1 Net present value accounting

In terms of cash flow, most business investments follow a similar pattern: money is sunk into creating an asset, which then operates to create a revenue stream. Clearly, a rational investor will expect that the turnover of the business will be sufficient to meet the running costs (workers, materials, services and taxes) and to repay the investment with some profit. But it is not only the arithmetic of income and expenditure that must ‘add up’ — timing, too, is crucial. Imagine, for example, a scheme in which backers were required to wait decades before seeing a return on their investment. Intuitively, it is clear that this would have little attraction — for one thing, the longer one has to wait for a return, the greater will be the risk of default; for another, an investor might guess that he could be dead before the scheme comes into profit. Clearly, there is a preference for returns to be delivered sooner rather than later. We must acknowledge, too, that a lender of money will expect to be recompensed for the risk taken when providing a loan, for the loss of an opportunity to do something else with the money and, not least, for the administration of the loan. These costs accumulate year on year and a convenient way of accounting for this is to discount future income and expenditure at an annual rate. The classical equation expressing the discount rate r is

r = 6 + в [5.1]

Here, 6 is the rate of pure time preference i. e. the additional value (expressed as a fraction or a percentage) that an immediate payment would be considered to have compared to a payment in a year’s time assuming that interest rates are zero. The parameter i is the (normalised) per-capita growth rate of consumption and в is a constant known as the elasticity of marginal utility or, equivalently, the coefficient of relative risk aversion.1 The parameter і approximates to the average rate of interest on capital and the multiplier в may therefore be seen as a measure of the risk of the venture compared to an investment, say, in safe government stocks. Typical (and easily remembered) values for 6, i and в are 2%, 2% and 2 producing a discount rate of 6%. The discount rate may also be seen as the rate of return that the proposer of a project (e. g. a would-be electricity generator) must offer the market in order to persuade it to invest in his project. A direct consequence of the application of this discount rate is that future revenues or costs are assumed to be worth less than they would be if they arose today.

The application of cost discounting (also known as net present value accounting) provides a standard means of assessing the financial viability of schemes in which investments, costs and earnings occur in different amounts and at different times. In the case of electricity generation it becomes possible to compare, for example, the cost of nuclear energy, where the capital costs are high and running costs are low, with combined cycle gas turbine (CCGT), which has exactly the opposite properties.

Following a similar algorithm to that for compound interest, if the discount rate is r, the value of an item that arises in year j is discounted by a factor (1+r)-. This applies whether the item is a debit or a credit. If the life of a power station is, say, 40 years and the discount rate is 6% (i. e. r = 0.06), the discount factor just before plant closure will be 0.10 so that, for instance, the income from electricity sales in year 40 will be assumed to be worth only 10% of its present day value. Thus, any discount rate, but especially a high one, will favour businesses (forms of electricity generation in this case) where the investment is quickly recouped. Situations where it takes many years to recover the investment will tend to be rejected. A secondary consequence of the method is that it becomes very difficult to argue the benefits of long-lived plant because, for example, income generated between, say, 60 and 70 years, is discounted so heavily. Thirdly, long­term costs, such as the inevitable expenditure on decommissioning of a nuclear power plant, are also discounted so that, when set against the up-front investment in plant, they may appear largely irrelevant. This approach seems to operate against sustainability and inter-generational equity, and some have proposed2 that net present value accounting should not be used over time periods of more than a few decades.

In fixing upon an appropriate discount rate, it is often argued that private investors will demand higher rates of return than governments. This may be rationalised on the grounds that governments are able to control some of the risks to which a private investor would be subject. It is also possible that a government may be willing to accept a lower rate of return on the investment, seeing it as a means of gaining the greater prize of economic growth.