Global Conclusion

The discount rate is a key parameter in economics because it determines how our societies value their future. The aim of this book was to help build a consensus on the social discount rate to use in the NPV decision rule: to find the discount rate which gives a positive NPV only for those projects that raise the sum of present and future generations’ felicity. In this book, I advocated the following set of principles:

1.  The driving force of discounting is the collective aversion to (intertemporal) inequalities which in the models in this book is represented by a concave relation between consumption and felicity. The relative aversion to inequality has been set to 2. This is normative and implies that one should be ready to give up as much as 4 euros of consumption from individual A to increase the consumption level of individual B by 1 euro, when A consumes twice as much as B.

2.  Following the Ramsey rule, safe real cash flows maturing within the next 5–10 years should be discounted at a rate that is two times the real growth rate of the economy. Assuming an expected growth rate of the economy around 2% per year, this yields a discount rate of 4% for short horizons.

3.  Because of large uncertainties about the evolution of our economies in the distant future, the long branch of the term structure of real discount rates should be decreasing. This is perfectly compatible with the time consistency of collective decisions. Given this uncertainty, the real discount rate for safe projects should converge to somewhere between 1% and 2% for distant maturities.

4.  Uncertain projects should be evaluated using the same discount rates, but to discount the certainty equivalents of their cash flows. In the special case in which these cash flows follow a geometric Brownian process as does aggregate consumption, this is equivalent to discount the expected cash flows at a rate adjusted for risk. This risk premium should be equal to 3% of the project’s beta, which measures the expected percentage increase in its net social benefit when aggregate consumption increases by 1%.

5.  The adaptability of projects should be valued by estimating option values.