The application also shows that the theoretically correct approach can be straightforward to apply. This can have real world consequences, including failing to make worthwhile investments to limit the arrival or spread of citrus canker because we are substantially underestimating the avoided costs from such investments. Hence, the standard approach underestimates the costs by hundreds of millions of dollars in the case of citrus canker. By contrast, under the standard approach, citrus canker is estimated to cost growers just $80 million. Under the theoretically correct approach, citrus canker is estimated to cost growers $320 million in present value terms over the next 50 years. To demonstrate the theoretically correct approach, we revisited a previous ABARES biosecurity application. Then discount the certainty equivalents based on the (real) risk-free discount rate. Where the costs and benefits are not known with certainty, estimate the certainty equivalents for the agricultural project in each year. A better approach is to address the time value of money (value of a dollar in the future relative to a dollar now) and risk separately. However, it only provides a good approximation under restrictive conditions. Some economists argue that a pragmatic alternative to the standard approach is to adjust the discount rate to account for project risk. However, the standard approach will always recommend the medium-risk alternative investment, given the higher expected return. For example, a zero-risk agricultural project with an expected return of 5 per cent might be preferred to a medium-risk alternative investment with an expected return of 7 per cent. In particular, it does not account for differences in riskiness between the proposed project and the alternative investment. This is the rationale for the recommended ‘central case’ discount rate of 7 per cent in most guidelines.īut the standard approach is not always a good approximation. The historical long run return on private investment across the Australian economy has been around 7 per cent (or slightly higher). Government economic appraisal guidelines tend to define the alternative as an investment in private assets across the economy. There are several ways to define the alternative investment and this affects the choice of discount rate. The standard approach is to discount based on the (real) expected return on the alternative investment. ![]() We do not want to invest in a project if it means forgoing a better alternative. One of the motivations for discounting is to account for the opportunity cost of capital. We need to discount future costs and benefits. This report explores both sides of the debate to provide rigorous and practical guidance on how economists should approach discount rates and the treatment of risk in their analysis of agricultural projects. ![]() If these criticisms hold, we are likely to be underestimating the merits of long-term projects versus short term projects and the merits of projects that reduce risk versus projects that increase risk, with implications for the quality of investment decisions. Critics have argued that the discount rate should be updated to reflect changing economic conditions and suggested, more fundamentally, that the theoretical basis of the standard approach is flawed. ![]() However, support for this position has eroded over time. Since the 1980s, most government economic appraisal guidelines in Australia have adopted a consistent approach set out in government economic appraisal guidelines. There is considerable debate around discount rates and the treatment of risk in economic analysis. Authors: Simon Hone, Peter Gooday, Ahmed Hafi and Jared Greenville Summary
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