How do governments make the decision to invest in a public project? Benefits for projects in infrastructure, education or health will often appear in the future, sometimes years after the project started.
Governments all over the world use an economic tool to make sure the value of the benefits generated by a project exceeds the cost. That is the “social discount” or “economic opportunity cost of capital”, a percentage rate at which the government discounts future benefits in order to compare the present value of benefits with that one of costs.
“Using the appropriate social discount rate is very important to make the best possible use of public resources,” says Andrea Coppola, World Bank economist and among the authors of the recent publication “Mexico: Estimation of the Economic Opportunity Cost of Capital for Public Investment Projects” that analyzes the social discount rate of the country. One of the report’s findings is that the economic opportunity cost of capital has been decreasing over the years.
We had a chat with him and he explained why it was important to revise this rate and what the findings mean for Mexico’s decision making.
Why did the World Bank undertake a review of the economic opportunity cost of capital of the Mexican Government?
In view of significant macroeconomic developments in recent years (for example, the significant improvement of Mexico’s credit rating), the Mexican government has requested the World Bank’s assistance in reviewing the social discount rate used in Mexico and the methodology used for its estimation. The technical review of the social discount rate takes into account the recent improvements in Mexico’s economic and financial structure as well as developments in international capital markets. Using an outdated social discount rate could prevent some important public investment projects from being approved.
Why is this tool important for the government?
The choice of the social discount rate can affect policy choices. Higher discount rates favor investment projects producing a positive impact in the shorter term. Lower discount rates favor projects with the higher benefits over a longer time horizon. Using the proper discount rate helps the Administration to assess the present and future costs and benefits of the investment proposals and identify a balanced portfolio of investments to be financed with public resources.
The report shows that the economic opportunity cost of capital has actually been going down in the last years and is less than was calculated before. What are the reasons for that?
The social discount rate is a function of several factors and the evolution of these factors implies that the social discount rate evolves over time. During the last years, the social discount rate has been going down for several reasons. One of the most important reasons is the significant improvement of Mexico’s credit rating. Investors now require a lower return to invest in Mexico. Another key reason is the development of capital markets in the country and the corresponding greater opportunities for savings. Going forward, the development of the financial sector in Mexico could further reduce the social discount rate.
And what does this mean for the government´s decision making, past and future?
The review of the social discount rate has no implications for the past investment decisions of the Administration. However, it has important implications for all the investment decisions that will be taken while considering the revised rate. The revised rate is significantly lower than the previous one (10% versus 12%). This implies that many projects that would have been rejected with the previous rate will now be given the proper consideration. The effect of using a lower rate is going to be particularly meaningful for all the projects generating benefits over a comparatively longer time horizons producing positive impacts for the current and future generations.
What other findings of the report are important to take into account?
Different investment projects imply different levels of risk. Project with higher risks should still be financed as long as they can provide higher returns. Therefore, the Administration should pay particular attention while evaluating high-risk projects by carefully considering appropriate upward adjustments to the social discount rate.