Technical Note 26
STMP Discount rate for Economic Appraisal
The discount rate used in the economic appraisal of public sector investments in the UK
is the Social Time Preference Rate, reflecting the best estimate of society’s preference for
consumption now rather than in the future. In the UK the STPR is estimated to be 3.5%1.
The STPR is an economic concept and is unrelated to commercial and financial discount
rates observed in financial markets2.
The discount rate used for economic appraisal in the UK is set by the UK Government and
used universally in appraising and preparing public sector investment projects for
government funding. This parameter is not generally reassessed or varied but applied as
an official standard input issued by Government for this purpose.
The explanatory text that follows below is paraphrased from the UK Treasury “Green
Book” guide to Appraisal and Evaluation in Central Government3 with full
acknowledgement of the source.
The estimation of the STPR includes four elements:
1.
An estimate of the pure time preference for consumption now rather than later
(estimated to be 0.5%/year and considered to be broadly universal);
2.
An estimate of catastrophe risk that there will be some event so devastating that
all returns from policies, programmes and projects are eliminated or
unpredictably altered (estimated to be 1.0%/year in stable economies). Examples
are premature obsolescence, natural disasters and major wars;
3.
An estimate of the elasticity of the marginal utility of consumption (estimated to
be 1.0 implying that the value of each unit of consumption falls as society
becomes richer such that when society enjoys twice today’s level of consumption
the value of each unit of consumption will be half the value today); and
4.
An estimate of the expected long run rate of growth of consumption/capita in the
economy (estimated to be 2%/year in the UK and 1.6%/year4 in Abu Dhabi overall
or 3.5%/year in the Abu Dhabi non-oil economy5).
1
See http://www.hm-treasury.gov.uk/data_greenbook_index.htm particularly Annex 6
The STPR was adopted in 2003. Before this date the official UK discount rate was equal to the Government’s estimated
cost of capital which was taken to be 6% (see Green Book 1997). The cost of capital rate of 6% was acknowledged to be
above the STPR but was justified to avoid bias against private sector supply
3
Available at the website in footnote 1 above
4
The overall Compound Annual Growth Rate of Real GDP/capita 2005 – 2030 projected in the Abu Dhabi Economic Vision
2030
page
131
see
http://business.abudhabi.ae/egovPoolPortal_WAR/appmanager/ADeGP/Business?_nfpb=true&_portlet.async=false&_pageL
abel=P6000178081229595408497&lang=en. The STPR requires the long run rate of growth/capita of consumption. This is
not generally available so is substituted by the GDP measure as a very close equivalent (the difference being savings which
should remain broadly stable as a proportion of GDP so that the growth rate of each measure is the same). We assume the
Economic Vision 2030 CAGR of GDP/capita at 1.6%/year continues into the future beyond 2030
5
The projected CARG of real non-oil GDP/capita growth 2005 – 2030 is 3.5%/year, source as footnote 4 above.
2
The STPR calculation is:
(Pure time preference + catastrophe
catastrophe risk) +
(long run rate of growth of consumption/capita *marginal utility of consumption)
For the UK the estimated STPR is 3.5%/year (0.5+1.0)+(2.0*1.0)
On the same basis the estimated indicative6 STPR for Abu Dhabi is 3.1%/year
(0.5+1.0)+(1.6*1.0), or 5.0%/year based on the non-oil economy projected rate of growth
of GDP/capita (0.5+1.0)+(3.5*1.0).
The purpose of the rate of economic growth term in the estimation of the STPR is to
reflect the ability of future generations to shoulder their appropriate burden of public
investment. With high rates of economic growth the costs imposed/benefits received by
future generations will be worth far less to them than the benefits foregone/costs
incurred to the present generation suggesting that the present generation should not
over invest to benefit future generations. If in the reality of Abu Dhabi the higher non-oil
rate of growth of GDP/capita is thought to reflect better the ability of future generations
to shoulder the burden of public investment the higher estimate of STPR is the more
appropriate.
The advice from the Abu Dhabi Department of Finance is that there is no official discount
rate to apply in the economic appraisal of public sector projects. In the absence of any
official Abu Dhabi discount rate for public sector investment we propose to use the
indicative Abu Dhabi STPRs calculated above representing lower and upper estimates of
an Abu Dhabi STPR.
It was suggested by the DoF contact that the rate proposed/adopted should reflect the
risk of the investment. In our view this is appropriate for discount rates adopted in
financial analysis and particularly by private sector investors considering PPP financing.
But for economic appraisal investment risk should be addressed by risk and/or sensitivity
analysis rather than by including any general risk premium in the basic discount rate
used for the economic appraisal.
As stated above the explanatory text and its underlying research results (with the
exception of the estimate of future growth of GDP/capita in Abu Dhabi) are drawn
directly from UK Government research and official guidance. We are not in a position to
advise the specific applicability of the three other components of the STPR to Abu Dhabi
but have no better information available. If DoT or other local agencies wish to advise on
the values to ascribe to any of these three other components we are happy to incorporate
these in a revised discount rate to be applied to the economic appraisal of the project.
6
Indicative because three of the four components of the estimated STPRs are transferred values not validated for Abu Dhabi
(and not validatable within the scope of this study)