Discount rates crucial in energy modelling

Discount rates are a crucial factor in energy and climate modelling and associated impact assessments. Why is that? Energy efficiency measures (e.g. in buildings) typically have relatively high upfront costs, which need to be recovered by savings over longer periods. Discount rates are thus used to attribute a value to future cash flows. The higher the discount rate, the lower the value we assign to future savings in today’s decisions. Consequently, high discount rates make energy efficiency measures and supporting policies look less attractive.

New infographic on discount rates

18 April 2018 – A new infographic by eceee that builds on eceee’s work on discount rates shows that virtually all EU Member States user lower discount rates for policy evaluation than the European Commission. Should the Commission use the average MS rate, a much more ambitious energy efficiency target could be justified. Download here.

New eceee report

Evaluating Our Future. The crucial role of discount rates in European Commission energy system modelling.
Download (pdf)
See press release 19 Oct 2015.

See presentation at hearing in European Parliament 21 October (SlideShare online or as pdf)


 

EU's 2030 energy and climate policy framework

When the European Commission presented its proposal and accompanying impact assessment for a 2030 energy efficiency and greenhouse gas (GHG) reduction target in the summer of 2014, the importance of energy efficiency did not seem to be sufficiently well addressed considering the available cost-effective savings potential (see eceee’s 2030 policy pages).

Very high discount rates being used as inputs for the underlying PRIMESenergy system scenarios were identified as a major reason for this under-valuation of efficiency (PRIMES is one of the major models used by the European Commission for assessing the economic impact of different EU energy policy options). If the assumed discount rates had been lower, analysts claimed, the Commission could have motivated a much more ambitious proposal, especially for energy efficiency.

About the new eceee report on discount rates

The new eceee report is entitled Evaluating Our Future and prepared by international energy and climate consultancy Ecofys for eceeeThe report follows on the Commission’s 2014 proposal and accompanying impact assessment for a 2030 greenhouse gas reduction and energy efficiency target.

One main concern with Commission modelling practice is the apparent mix of private and societal discount rates. The authors point at the lack of transparency as to why the same high discount rates for modelling private investment behaviour of individuals and companies are applied to the evaluation of societal costs and benefits of policies.

The report also reveals that the Commission in its impact assessments applies many times higher societal discount rates than individual Member States are doing in their own policy evaluation work.

According to the report, neither economic theory nor actual Member State practice provide good reasons for the major differences between discount rates observed to be used in EU Impact Assessments and individual Members State impact assessments. In fact, some Member States explicitly follow the clear advice from earlier EU Impact Assessment Guidelines to use a discount rate of 4%.

Some of the conclusions in “Evaluating our future”

  • The use of discount rates for modelling of individual investment decisions and for the evaluation of energy system costs from a societal perspective must be kept apart. This is currently not the case.
  • Member States use much lower discount rates than recent EC Impact Assessments. Neither economic theory nor actual Member States’ practice provide good reasons for the major differences between discount rates observed to be used in EU Impact Assessments and Member States individual impact assessments.
  • Discount rates used in EC Impact Assessments for determining the annual total energy system costs should be revised. Preferably an EU-wide social discount rate should be calculated based on existing theory. If no consensus can be found about going that way, an average EU Weighted Average Capital Cost (WACC) could be calculated. Either way, the assumed result will be in the range of 3% to 6%, as compared to the 17.5% used for households in the Impact Assessment for the 2030 energy and climate policy framework.
  • The translation of barriers and policy measures into “subjective” discount rates needs to be transparent. In PRIMES, the “subjective discount rate” is the major parameter mimicking individual decision making about technology choices. However, there is no common understanding on how to translate individual behaviour and time/risk preferences into subjective discount rates. This should be the reason for giving a fully transparent explanation for how the discount rates used in PRIMES modelling are set and how they adapt as a consequence of targeted energy policies.
  • The role of Impact Assessments is to support and not to replace policy making. Their inputs, logic and outputs should be fully transparent. Outputs should always be tested against other modelling tools.

eceee resources

New report: Evaluating Our Future. The crucial role of discount rates in European Commission energy system modelling (19 Oct 2015) [Download report]. [Press release]

BRISKEE. eceee is engaged in a Horizon 2020 research project on implicit discount rates in the private sector: http://briskee.eu

briskee logo

eceee columns

First victory in the battle of the discount rates (Brook Riley)

Battle of the discount rates (Brook Riley)

External resources

Discount rates in energy system analysis - discussion paper

BPIE (2015) commissioned Fraunhofer ISI to investigate the use of discount rates in energy efficiency policy modelling with a focus on the building sector. The paper summarises their use in a number of reports and argues that the use of high discount rates to map non-economic barriers and bounded rationality is not suitable. (See pdf)

The use of Discount Rates in Policy Modelling

Report by Cambridge Econometrics, March 2015. (See pdf)

Entranze

Policies to enforce the transition to nearly zero energy buildings in the EU-27. The objective of the ENTRANZE project is to actively support policy making by providing the required data, analysis and guidelines to achieve a fast and strong penetration of nZEB and RES-H/C within the existing national building stocks. (See project web site)