Columnists: Brook Riley, Rockwool International

Published on: 1 Apr 2015

Battle of the discount rates

Discount rates are a lot like quantitative easing, which is to say they sound dull but in fact are hugely important.

In climate and energy modelling, the discount rate is the value used to assess the costs and benefits of different scenarios. Put simply, the higher the discount rate, the higher the estimated costs – and the less attractive the policy.

The European Commission is currently using an extremely high discount rate of 17.5% for energy efficiency. The result: ambitious efficiency policies look about as attractive as having your teeth removed. And because scenarios for high efficiency and renewables tend to go hand in hand, wind, solar and other clean energy sources look just as unattractive.

This has very negative consequences for EU decisions about emissions cuts, security of supply, employment and energy costs.

According to Commission analysis carried out last year, a 40% by 2030 energy efficiency target would reduce gas imports by 40% and increase GDP by 4.45%. But because efficiency scenarios were modelled with such a high discount rate, a 40% target was judged too expensive even to be considered.

This begs the question, is a 17.5% discount rate justified? It is, if you assume that renovating a house in Europe is a riskier enterprise than drilling for oil in Iraq on the edge of Islamic State territory. Here's a table comparing different discount rates.

I confess I get seriously angry when I look at these numbers. As I said, the higher the rate, the less attractive the policy. The Commission consistently says efficiency and renewables are essential to keeping climate change under control. The International Energy Agency says the same thing – and it also says that at current rates we're on track to devastating levels of 4-6°C of global warming by the end of the century. The celebrated US economist Jeremy Rifkin says this would be an 'extinction event'.

So when I see Commission officials are keeping the discount rate for efficiency at such a high level, knowing that it will discourage policymakers from supporting ambitious action, I think the verdict 'criminally irresponsible' is accurate.

Last month I asked Cambridge Econometrics – which has done a lot of analytical work for the Commission – for its opinion. They explain that standard practice would be to use a rate of 4% or less. You can read their report here .

If I sound like I'm ranting against the Commission, let me put the record straight. There is a strong campaign already underway inside the Commission to lower the discount rate for efficiency.

Last year, the Commission's energy department modelled three scenarios for the 2030 efficiency target: a 4% discount rate, a decreasing rate (falling from 17.5% to 10%), and the 17.5% rate. The cost differences were jaw-dropping: 600 billion Euros between the 4% and the 17.5% rates. These numbers helped convince Germany, France, Denmark and five other member states to write to the Commission in support of higher ambition.

But in the end, the cost assessments using lower rates were deleted from the Commission's final analysis. Only the results calculated with the 17.5% rate were retained.

Why? Here is what I believe to be the main reason. Connie Hedegaard in her last weeks as Climate Commissioner spoke openly about the opposition to lower rates from Emissions Trading System (ETS) purists in her department.

She said they feel threatened by efficiency and renewables, which they believe will undercut the carbon price. And keeping the high discount rate for efficiency is a perfect way to make the economics favour the ETS (or pretend to).

The narrow view of emissions-trading-above-all-else in EU climate and energy policy has taken a beating over the past year, especially with statements from prominent officials that it's perfectly possible for the ETS to work in conjunction with renewables and efficiency policies. But it's deeply ingrained in key units of the Commission.

Here's a table summarising the top 'justifications' for keeping the 17.5% – and what I think are compelling arguments for rejecting them.

If you've read this far, I hope you're asking 'what can we do about it?' Lots, fortunately. This year the Commission is updating its modelling projections for 2030 and beyond (known as the PRIMES reference scenario). It's the perfect opportunity to lower the discount rate for efficiency.

There are Commission officials both in favour and opposed to a revision – it’s just a matter of tipping the balance. If only a fraction of the experts who make up the ECEEE network take up this issue and start calling for an honest rate for efficiency, I'm positive we'll win. Let's do it!

Other columns by Brook Riley