Turning Policy Into Performance: Determining A Discount Rate For Decarbonization

Welcome to the newest installment of a new blog series called Turning Policy into Performance. In this series, we'll take a look at how states can implement decarbonization and climate goals with energy efficiency programs.

Achieving decarbonization goals will require a paradigm shift in energy efficiency program planning – away from short-term energy savings and towards long-term carbon savings. In previous blogs, we have looked at adding non-energy benefit metrics to the cost-benefit analysis to reflect the equity, climate, and market transformation impacts of programs. This blog will focus on a new component of cost-benefit analysis – the discount rate – and why it is important to consider a jurisdiction-specific discount rate to properly reflect a state’s energy efficiency, climate, and equity priorities.

What is a Discount Rate?

The discount rate is to determine when and for how long the impacts of an investment will be seen. It is a percentage, applied in the cost-benefit analysis, to measure how financial investments will be valued in the future. For energy efficiency programs, each jurisdiction can use different discount rates, as they are established in energy efficiency program filings and dependent on policy priorities.

The discount rate represents the perspective of the group who benefits from the investment and policies of the jurisdiction. To establish this perspective, it balances three factors that impact future investments: inflation, time, and risk. Inflation accounts for the loss of value of the investment over time, that a dollar today will not have the same purchasing power as a dollar year from now. Time accounts for the length of time from which the benefits are expected to stem. Risk recognizes that investments may not always work out, and attempts to estimate the likelihood that an investment will provide expected benefits.

A higher discount rate reflects an investment that will provide short-term benefits (five to eight percent) while a lower discount rate reflects an investment that will provide the same or more benefits to future generations (negative percent to three percent). Small changes in the discount rate can create huge impacts. For example, a difference in a discount rate of three percent to two percent with the social cost of carbon will bring the price per ton from $51 to $119. This price difference can allow for programs that encourage fuel switching and prioritize strategic electrification to pass the cost-benefit analysis.

In the energy efficiency space, the discount rate seeks to answer the question of how much saving one KW now will benefit future generations. Because

energy efficiency programs are based on utility investments, most jurisdictions relay on the weighted cost of capital (WACC). A WACC is the return on investment utilities expect to make when they build out infrastructure. The rationale for the use of the higher discount rate for energy efficiency investment is that utilities invest in the programs and programs create short-term benefits from energy savings. But the transformation to energy efficiency programs that also decarbonize, will mean shifting objectives from short term “least-cost” energy resources to achieving long-term equity and climate policy goals. Some jurisdictions do reflect these benefits already by using a societal discount rate, three percent or lower. One common ground between these two perspectives is creating a regulatory based or jurisdiction-specific discount rate.

Creating a Jurisdiction-Specific Discount Rate for Decarbonization

States are setting climate and equity policy goals that will require changes to current energy regulation and utility business models. For the discount rate, similar to a jurisdiction-specific cost-benefit test, states can utilize a jurisdiction-specific discount rate to align energy efficiency, demand response programs, and long-term infrastructure planning with state climate and equity efforts. To help states in this process, the NSPM presents considerations for establishing a regulatory- or jurisdiction-specific discount rate.

Here are four reasons for a jurisdiction to consider adjusting their discount rate.

• A jurisdiction-specific discount rate will ensure the perspective of ratepayers and society is reflected. While the WACC is an appropriate discount rate for business investment, using the WACC means that only the perspective of the utility is considered. A discount rate should reflect the perspective of those funding the investment and benefitting from it. Ratepayers fund energy efficiency programs via a surcharge on their bill, and the benefits accrue to participants of the program plus society generally through the impact of lowering energy use and emissions. Therefore, a lower discount rate, such as a societal discount rate would better reflect these perspectives.
• A jurisdiction- specific discount rate can reflect the lower risk associated with energy efficiency investments. There are significant differences in the financial risks of investing in energy efficiency programs versus traditional power plants. This is because energy efficiency is funded by a systems benefit charge paid by most consumers, so there is little risk that the utility will not recover costs. Whereas other energy investments, such as power plants, are riskier investments as they can be abandoned and take longer time to provide a payback.
• A jurisdiction-specific discount rate can embed principles of intergenerational equity into the cost-benefit analysis. Intergenerational equity refers to ensuring programs and policies benefit both current and future generations. A lower discount rate reflects the societal benefits that stem from supporting and benefiting  future generations. Using a lower or societal discount rate can reflect policies and support programs that invest in future generations in a more meaningful way.
• A jurisdiction-specific discount rate reflects environmental and decarbonization goals of the state. Discounting assumes that financial investments will lose value over time, yet removing carbon from the atmosphere will likely present more benefits in the future. This means that programs that seeks to lower or reduce emissions now should consider using a societal or even zero discount rate. This lower rate would be appropriate because energy efficiency is a cost-effective resource that is able to reduce GHG emissions now by removing long-term pollutants from the air.

Conclusion

Achieving decarbonization goals requires a paradigm shift in energy efficiency program planning – away from energy savings and towards carbon savings. One part of this shift is determining an appropriate discount rate for cost benefit analysis, one that is able to fully value the benefit that energy efficiency has for present and future generations.