The Discount Rate in the Plan

Wally GibsonNWPPC Power Committee – Kah-Nee-Ta

July 15, 2003

July 15, 2003 2

Background Fundamentals

• Net present value of system cost• One of the principal decision criteria• Combines costs over time into one summary number

• Discount rate = rate of time preference• Used to calculate present value – compares $ in different years

• Choose $100 today or $110 next year• Components

• $100 = present value (PV)• $110 = future value (FV)• 10% = discount rate (R) – in this example, the rate that

makes them equal• PV = FV / (1+R) or FV = PV x (1+R)

July 15, 2003 3

Why is the Discount Rate Needed and Important? – 1

Undiscounted annual $

0

50

100

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450

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Year

Annual $

Res 1 eg Gas

Res 2 eg Consv

July 15, 2003 4

Why is the Discount Rate Needed and Important? – 2

Present valued annual $: Sum = $1,500 for each at 10%

0

50

100

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450

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Year

Ann

ual p

rese

nt v

alue

di

scou

nted

$

Res 1 eg Gas

Res 2 eg Consv

July 15, 2003 5

Why is the Discount Rate Needed and Important? – 3

Annual Cost

0

50

100

150

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300

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400

450

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Year

$

Res 1 eg Gas

Res 2 eg Consv

PV Res 1 eg Gas

PV Res 2 eg Consv

July 15, 2003 6

Discount Rate Affects Resource Choices

• Higher rate: future counts less

• Lower rate: future counts more

Effect of Discounting on Annual Cost

0

50

100

150

200

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450

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Year

$

Res 1 eg Gas

PV Res 1 at 10%

PV Res 1 at 5%

July 15, 2003 7

How to Choose the number?

• All perspectives based on market interest rates• Alternative perspectives – taxes make the difference

• Regional consumer: household and business consumers• Personal and business income taxes give low net returns

• Corporate perspective – standard in financial literature• Focuses on source of funds for utilities, including all types

• National Perspective – typically recommended for national government investments• Ignores all income taxes, focuses on private opportunity cost

• Council has used regional consumer’s and corporate perspectives in the past

July 15, 2003 8

Real vs. Nominal Terms

• Real = adjusted for inflation• Inflation taken out

• Constant purchasing power

• Nominal = contains inflation effect

• Nominal = real + inflation (close approximation)

July 15, 2003 9

Corporate Perspective

• Standard in the financial literature and widely used in this and other industries

• Firm’s cost of capital (real terms, at 2.5% inflation)• IOUs: ~ 5 to 5.5%

• Co-ops: ~ 3.5%

• Bonneville: ~ 3%

• Municipals: ~ 2.5%

• Built up: forecasts of 10 year Treasury note yield and inflation, historic rate spreads, with medium term focus

• Recommendation: 4% in real terms

July 15, 2003 10

Caveats

• Corporate perspective implies that Council’s composite number is not correct for any individual load serving entity that is acquiring resources• The perspective can be used by all; but each will have its

own discount rate based on its own cost of capital

• Treatment of project risk• No special adjustments built into discount rate

• Implies project risk should be dealt with explicitly in other parts of the analysis, as Council analysis will do

July 15, 2003 11

Comments Received – Approach

• Support proposed cost of capital approach • Idaho, Oregon PUC staffs, Washington UTC

• PPC staff

• Renewables Northwest consultant, based on argument about avoiding capital market distortion

• Support using consumer’s perspective approach • NW Energy Coalition

• Recommendation• Support proposed cost of capital approach

July 15, 2003 12

Comments Received – Specifics 1

• The inflation rate may be too high• Paper noted that implicit forecasts of bond market lower

than explicit forecasts of economists – Not clear what is happening here

• Current questions about deflation – Not clear how extensive it is (goods vs. services, temporary vs. trend) and whether it has affected real rates.

• Recent economists’ forecasts of near-term inflation and 10 year note rates have dropped – Difference (real rate) is about the same and still consistent with long term averages – real rate is what we end up using

July 15, 2003 13

Comments Received – Specifics 2

• Council should provide high and low discount rate estimates to help BPA and regulators evaluate robustness of alternative resource plans• Agree that this is one test of robustness – Could use 3%

and 5%

• On the other hand, corporate cost of capital approach gives more certainty about the right number to use for individual entities making investment decisions than does using the consumer perspective, which is hard to quantify

July 15, 2003 14

Comments Received – Specifics 3

• Reason for choosing 5.2% for reference 10 year Treasury note forecast was not clear• Judgment was used to emphasize early years, starting in

2004, of a 10 year forecast.

• More recent forecasts lower the nominal rate somewhat in early years as well as lowering the inflation forecast, leaving the real rate about the same, as noted earlier

July 15, 2003 15

Comments Received – Specifics 4

• The discount rate should be different for different types of resource because risk and cost of capital are different

• The discount rate should be the same for different resource types because it should be a consumer’s discount rate, which is indifferent to resource type

• Response• There are arguments for and against in literature.

Recommend investment characteristics be recognized separately in the analysis rather than in discount rate

July 15, 2003 16

Comments Received – Specifics 5

• Utilities increasingly expense conservation investments, implicitly using consumer financing. Codes and standards should explicitly use consumer financing. This should be incorporated into calculation.• Council’s analysis of conservation measures uses utility

cost of capital for utility-financed part and mortgage cost for codes. Expensing is not the same as consumer financing.

July 15, 2003 17

Comments Received – Specifics 6

• Environmental costs should have a 0% discount rate• To the extent environmental attributes can be

characterized by dollar values, they are subject to the same phenomenon as other costs and benefits: a positive interest rate makes future society more wealthy and better able to pay costs

• To the extent environmental attributes are perceived to be more valuable in the future, the right approach is to raise the benefit, not lower the discount rate

• To the extent environmental attributes are not quantifiable, they are not subject to discounting in any case