NRCS Use of Discount Rates in Conservation Programs and Projects

Mark Xu NRCS67th Annual SWCS International Conference

Objectives: Clarifications and RecommendationsCorrect interpretation of Federal

regulations on social discount ratesNon-water resources: regulatory and non-

regulatory analysisWater resources

the appropriate choice of private discount rates

the appropriate use of nominal and real rates for both social and private discount rates.

Discount Rate DefinitionWhat is discount rate: In economic

analysis, a discount rate is an interest rate used in computations of present value.

Discount rate formula:

nrFVPV

1

1

Discount Rate Effect: $1,000 Future Cash Flow 10 Years from Now

Social and Private Discount RatesDefinition

Private discount rate: an interest rate used in a private benefit-cost analysis (BCA) when the analysis is to determine the profitability of the project.

Social discount rate: an interest rate used to compare benefits and costs that occur at different times based on the rate at which society is willing to make such trade-offs.

Difference: all social cost and benefits accounted for?

Usage: social vs. private benefit and cost analysis

Economic Theory behind Private Discount RateOpportunity cost of capitalRate of return from next best alternativeLoan rate of the accessible capital

Economic Theory behind Social Discount RateTwo common interpretations:

Social opportunity cost (SOC): a public investment may displace private investment and the opportunity cost of capital in the private sector should be taken into account in the investment decision of public funds.

Social time preference (STP): a public investment diverts funds from consumption and thus consumer’s time preference for money should be considered.

Main difference between SOC and STP: capital income tax

Treatment of Risk in Discount RateIn theory, risk premium could be a part of

discount rate. In practice, risk premium is often excluded in

base case discount rate because:the risks of a public investment are publicly borne,

the total cost of risk-bearing is insignificant.project specific risks can be modeled by calculating

the expected value of the cost or benefit.sensitivity analysis of different discount rate after

base case analysis could cover potential risks in discount rate variation

Nominal vs. Real Discount RateDefinition: Real interest rate is the

difference between nominal interest rate and inflation rate.

Either nominal or real discount rate can be used, so long as it is consistentUse nominal discount rate if benefits and costs

are measured in nominal dollars.Use real discount rate if benefits and costs are

measured in real dollars.No mismatching.

Common Practice in the Federal GovernmentHistorically, long-term interest rates on

government bonds for a proxy of the riskless cost of capital while the choice of the risk premium is left at the discretion of the analyst.

By early 1970, OMB recommended that all government agencies use a discount rate of 10 percent for the BCAs.

Discount rate guidelines are periodically revised since then that covers benefit-cost, cost-effective, and economic impact analysis.

Application to NRCSNRCS economists regularly conduct economic analysis

forFederally-funded conservation programs and projectsFarm-level conservation investments for farmers

According to NRCS policy (NRCS Title 200 General Manual-Economics), discount rates should be based on: OMB Circular A-94, Guidelines and Discount Rates for

Benefit-Cost Analysis (BCAs) of Federal Programs Economic and Environmental Principles and Guidelines for

Water and Related Land Resources Implementation Studies (the P&G)

There is no instruction on the use of private discount rates.

Federal Regulations on Discount Rates for Non-Water Resources with External Social Benefits: non-regulatory Analysis

Governing regulations: OMB A-94, Guidelines and discount rates for benefit-cost analysis (BCAs) of Federal programs.Base case rate: 7% real rateLower case sensitivity analysis: 3% real rateHigher case sensitivity analysis: 10% real

rate

Federal Regulations on Discount Rates for Non-Water Resources with External Social Benefits : regulatory Analysis

Definition of regulatory analysis: "economically significance test:” A regulatory action is economically significant if it is anticipated (1) to "have an annual effect on the economy of $100 million or more" or (2) to "adversely affect in a material way the economy, a sector of the economy, productivity, competition, jobs, the environment, public health or safety, or State, local, or tribal governments or communities."

Governing regulations: OMB A-94, : 7% real rate OMB A-4, "Regulatory Analysis“: 3% real rate

Federal Regulations on Discount Rates for Federal Projects with No External Social Benefits

Governing regulation: OMB A-94. Cost saving is the sole focus for these projects. Real or nominal treasury borrowing rate on treasury notes

and bonds of comparable maturity. An example: 2012 Nominal and real discount rates for

federal projects with no external social benefits

  3-Year 5-Year 7-Year 10-Year 20-Year 30-Year

Real Rate    0.0    0.4    0.7     1.1     1.7     2.0

Nominal Rate    1.6    2.1    2.5    2.8     3.5     3.8

Federal Regulations for Water Resources Discount RatesGoverning regulations

Water Resource Development Act of 1974: discount rate formula using average market yields during the preceding fiscal year on government securities that have 15 years or more to maturity, subject to a ¼% maximum annual rate of change.

P&G: use benefits and costs in real term.

Water Resources Discount Rates: 1974-2012

Table 2

Fiscal Year

Water Resources Discount Rate

Fiscal Year

Water Resources Discount Rate

Fiscal Year

Water Resources Discount Rate

1974 5.625% 1987 8.875% 2000 6.625%1975 5.875% 1988 8.625% 2001 6.375%1976 6.125% 1989 8.875% 2002 6.125%1977 6.375% 1990 8.875% 2003 5.875%1978 6.625% 1991 8.750% 2004 5.625%1979 6.875% 1992 8.500% 2005 5.375%1980 7.125% 1993 8.250% 2006 5.125%1981 7.375% 1994 8.000% 2007 4.875%1982 7.625% 1995 7.750% 2008 4.875%1983 7.875% 1996 7.625% 2009 4.625%1984 8.125% 1997 7.375% 2010 4.375%1985 8.375% 1998 7.125% 2011 4.125%1986 8.625% 1999 6.875% 2012 4.000%

Inconsistency in Water Resources Discount RatesThe problem: a discount rate that is developed

based on nominal interest rate but used as real rate

Negative impact of mismatching negative discount rate with benefits and costs in real terms: artificially raise the discount rate and thus puts water resource projects in disadvantage positions

Suscepable to the negative impact of high inflation environment

With External Social

Benefits?Annual nominal or real interest rates based on treasury notes and bonds of specified maturities (OMB Circular A-94)

Regulatory Analysis?

NoYes

Both 7 percent and 3 percent real rates (OMB Circulars A-4 & A-94)

Water Resources?

Yes No

Annual nominal interest rate derived from an average interest rate for long term treasury bills, using as a real rate (WRDA 1974, P&G)

Base case: 7 percent real rate. Sensitivity analysis: 3 percent and 10 percent real rate. Alternative rates may be used with OMB approval (OMB Circular A-94)

Yes No

Summary of Federal Regulations on Discount Rates

Factors Affecting Loan Rates for FarmersTiming of the projectLoan durationProject typeFunding sourceInflation rateFarmer’s credit record

Average Rate of Return of the U.s. Farming Sector, 2008-2012F

Financial measures 2008 2009 2010 2011F 2012F Average

Farm equity ($ billion) 1,781.7 1,812.5 1,944.0 2,095.0 2,220.2 1,970.7

Net farm income ($ billion) 84.7 61.6 79.1 98.1 91.7 83.1

Returns to operators ($ billion) 76.5 53.5 70.4 88.1 81.0 73.9

Rate of return on equity for farm sector 4.75% 3.40% 4.07% 4.68% 4.13% 4.21%

Rate of return on equity for operators 4.30% 2.95% 3.62% 4.21% 3.65% 3.75%

Recommendation #1For regulatory analysis of Federal programs for non-water resources, NRCS analysts are obligated to use both seven percent and three percent real discount rates specified in OMB Circular A-94 and Circular A-4.

Discussions about Recommendation #1The BCA for the new Farm Bill and similar studies that pass the "economically significant” test for regulatory analysis should use both seven percent and three percent real discount rates in the studies.

Recommendation #2For non-regulatory analysis of Federal programs and projects for non-water resources, NRCS analysts may use seven percent real rate for base case analysis and three percent and 10 percent real rates for sensitivity analysis as recommended in Circular A-94, or they may choose an alternative discount rate with OMB concurrence.

Discussions about Recommendation #2 The rating and ranking tools used by NRCS for allocating Federal funds to non-water resource programs and individual non-water resource BCAs should use seven percent real rate as base case discount rate, and use three percent and ten percent real rates for sensitivity analysis, unless alternative rates are used with OMB approval.About using an alternative discount rate for non-water resources projects

Rationale for using an alternative discount rate: real rate of return on equity in farming sector. Need coordinated action within USDA. Need OMB approval.

Do not mistakingly use discount rates for Federal projects with no external social benefits for conservation analysis.

Recommendation #3All NRCS watershed public projects, including PL-566, Pilot watershed, and Rehab projects, should use the water resources discount rate as real discount rate based on current statute and regulation. However, the inconsistency in using a nominal rate as real rate may need to be addressed in the future, especially in a high inflation environment.

Discussions about Recommendation #3 Two possible ways to resolve the inconsistency issue

Revise the P&G to allow costs and benefits for water resource projects to be evaluated in nominal terms. --- Such a revision would need a coordinated effort of all major Federal water resources development agencies and through the Council of Environmental Quality (CEQ). Revise the discount formula in WRDA 1974 to base the discount rate on real interest rates. This will need an act of Congress.

Is it really necessary to use a separate discount rate for water resources projects?Low priority item for NRCS because of the reduce presence of NRCS in water resources projects and the current low inflation environment.

Recommendation #4Private discount rate for private BCA for a loan-funded project should be the higher of the two: the accessible loan rate for the project and the rate of return for alternative best investment project. Private discount rate for a farmer funded project should be the rate of return for alternative best investment project.

Discussions about Recommendation #4 Using a private discount rate in a private BCA for farmers, not for proper allocation of Federal funds Either real or nominal rate is ok so long as it is consistent. Data availability is the key to determine whether to use real or nominal rate. Real discount rate is preferred in most cases when both real and nominal data are available because of the difficulty involved in predicting future inflation.