The Discount Rate in the Plan Wally Gibson

The Discount Rate in the Plan Wally Gibson NWPPC Power Committee – Kah-Nee-Ta July 15, 2003

Background Fundamentals • • • Net present value of system cost • One of the principal decision criteria • Combines costs over time into one summary number Discount rate = rate of time preference • Used to calculate present value – compares $ in different years Choose $100 today or $110 next year • Components • $100 = present value (PV) • $110 = future value (FV) • 10% = discount rate (R) – in this example, the rate that makes them equal • PV = FV / (1+R) or FV = PV x (1+R) July 15, 2003 2

Why is the Discount Rate Needed and Important? – 1 July 15, 2003 3

Why is the Discount Rate Needed and Important? – 2 July 15, 2003 4

Why is the Discount Rate Needed and Important? – 3 Annual Cost 450 400 Res 1 eg Gas Res 2 eg Consv PV Res 1 eg Gas PV Res 2 eg Consv 350 $ 300 250 200 150 100 50 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Year July 15, 2003 5

Discount Rate Affects Resource Choices • • Higher rate: future counts less Lower rate: future counts more July 15, 2003 6

How to Choose the number? • • All perspectives based on market interest rates Alternative perspectives – taxes make the difference • • Regional consumer: household and business consumers • Personal and business income taxes give low net returns Corporate perspective – standard in financial literature • Focuses on source of funds for utilities, including all types National Perspective – typically recommended for national government investments • Ignores all income taxes, focuses on private opportunity cost Council has used regional consumer’s and corporate perspectives in the past July 15, 2003 7

Real vs. Nominal Terms • Real = adjusted for inflation • • Inflation taken out Constant purchasing power Nominal = contains inflation effect Nominal = real + inflation (close approximation) July 15, 2003 8

Corporate Perspective • • Standard in the financial literature and widely used in this and other industries Firm’s cost of capital (real terms, at 2. 5% inflation) • • • IOUs: ~ 5 to 5. 5% Co-ops: ~ 3. 5% Bonneville: ~ 3% Municipals: ~ 2. 5% Built up: forecasts of 10 year Treasury note yield and inflation, historic rate spreads, with medium term focus Recommendation: 4% in real terms July 15, 2003 9

Caveats • Corporate perspective implies that Council’s composite number is not correct for any individual load serving entity that is acquiring resources • • The perspective can be used by all; but each will have its own discount rate based on its own cost of capital Treatment of project risk • • No special adjustments built into discount rate Implies project risk should be dealt with explicitly in other parts of the analysis, as Council analysis will do July 15, 2003 10

Comments Received – Approach • Support proposed cost of capital approach • • Support using consumer’s perspective approach • • Idaho, Oregon PUC staffs, Washington UTC PPC staff Renewables Northwest consultant, based on argument about avoiding capital market distortion NW Energy Coalition Recommendation • Support proposed cost of capital approach July 15, 2003 11

Comments Received – Specifics 1 • The inflation rate may be too high • • • Paper noted that implicit forecasts of bond market lower than explicit forecasts of economists – Not clear what is happening here Current questions about deflation – Not clear how extensive it is (goods vs. services, temporary vs. trend) and whether it has affected real rates. Recent economists’ forecasts of near-term inflation and 10 year note rates have dropped – Difference (real rate) is about the same and still consistent with long term averages – real rate is what we end up using July 15, 2003 12

Comments Received – Specifics 2 • Council should provide high and low discount rate estimates to help BPA and regulators evaluate robustness of alternative resource plans • • Agree that this is one test of robustness – Could use 3% and 5% On the other hand, corporate cost of capital approach gives more certainty about the right number to use for individual entities making investment decisions than does using the consumer perspective, which is hard to quantify July 15, 2003 13

Comments Received – Specifics 3 • Reason for choosing 5. 2% for reference 10 year Treasury note forecast was not clear • • Judgment was used to emphasize early years, starting in 2004, of a 10 year forecast. More recent forecasts lower the nominal rate somewhat in early years as well as lowering the inflation forecast, leaving the real rate about the same, as noted earlier July 15, 2003 14

Comments Received – Specifics 4 • • • The discount rate should be different for different types of resource because risk and cost of capital are different The discount rate should be the same for different resource types because it should be a consumer’s discount rate, which is indifferent to resource type Response • There arguments for and against in literature. Recommend investment characteristics be recognized separately in the analysis rather than in discount rate July 15, 2003 15

Comments Received – Specifics 5 • Utilities increasingly expense conservation investments, implicitly using consumer financing. Codes and standards should explicitly use consumer financing. This should be incorporated into calculation. • Council’s analysis of conservation measures uses utility cost of capital for utility-financed part and mortgage cost for codes. Expensing is not the same as consumer financing. July 15, 2003 16

Comments Received – Specifics 6 • Environmental costs should have a 0% discount rate • • • To the extent environmental attributes can be characterized by dollar values, they are subject to the same phenomenon as other costs and benefits: a positive interest rate makes future society more wealthy and better able to pay costs To the extent environmental attributes are perceived to be more valuable in the future, the right approach is to raise the benefit, not lower the discount rate To the extent environmental attributes are not quantifiable, they are not subject to discounting in any case July 15, 2003 17