3. Discounting the Future in Cost-Benefit Analysis
Time Preference, Discounting, and Economic Valuation
Taha Chaiechi
3.1. Time Value of Money and Opportunity Cost
🔍 What It Is
The Time Value of Money (TVM) is a core principle in economic and financial analysis which states that a dollar today is worth more than a dollar in the future due to its potential earning capacity. This concept underpins discounting practices in Cost-Benefit Analysis, where future costs and benefits are adjusted to reflect their present value. Closely linked is the concept of Opportunity Cost, which represents the value of the next best alternative foregone when a decision is made. In public investment, this means that deploying resources to one project inherently means sacrificing potential gains from another. Together, TVM and opportunity cost help ensure that resources are allocated efficiently across time and competing priorities.
A rigorous understanding of discounting in Cost-Benefit Analysis (CBA) requires first establishing the economic rationale for why future costs and benefits must be converted into present values. Two core economic principles provide this rationale: the time value of money and opportunity cost. These concepts, deeply rooted in microeconomic theory, form the intellectual underpinnings of intertemporal decision-making and investment appraisal. Without a firm grasp of these ideas, the logic behind discounting, and the significance of choosing an appropriate discount rate, can be easily misunderstood.
The Time Value of Money (TVM)
First let’s focus on the time value of money (TVM). TVM is a foundational concept in economics and finance that posits that a sum of money holds greater value in the present than it does in the future (Boardman et al., 2018). This is because money has the potential to earn returns over time if invested productively. Therefore, when comparing monetary flows that occur at different points in time, it is necessary to discount future values in order to express them in equivalent present value terms.
From an economic standpoint, TVM reflects two key ideas: the earning potential of capital and the inherent preference for current over future consumption, also referred to as positive time preference. Individuals and institutions prefer to receive benefits now rather than later, not only due to uncertainty about the future but also because resources available today can generate additional value through investment or consumption.
As Mishan and Quah (2020) argue, “time preference is intrinsic to human behaviour and any rational economic model must account for it when assessing future economic flows.” This preference implies that future benefits and costs must be adjusted downward when evaluated in today’s terms to reflect the foregone returns from alternative uses of capital.
Mathematically, this is represented through discounting, whereby each future cost or benefit is multiplied by a discount factor that reduces its present value in proportion to its temporal distance from the present.
📌Example
If $1,000 is received today and can be invested at an annual interest rate of 5%, it will be worth $1,276 in five years. Conversely, a benefit of $1,276 expected five years from now is only worth $1,000 today in economic terms, when discounted at 5%.
The implications of this are particularly important in long-term public investments—such as infrastructure development, health interventions, or environmental policies—where the majority of benefits are realised in the distant future. Without applying the time value of money principle, such projects may appear disproportionately beneficial or detrimental based on nominal values, rather than their true economic worth.
Opportunity Cost: The Economic Trade-off of Time
Closely linked to TVM is the concept of opportunity cost, which is defined as the value of the next best alternative that is forgone when a resource is used in a particular way (Mishan & Quah, 2020). In the context of CBA, opportunity cost plays a critical role in determining how future benefits and costs should be evaluated.
Resources—be they financial, human, or environmental—are inherently scarce. Allocating capital to a particular investment implies foregoing its use elsewhere, where it might have generated different, potentially higher returns. As a result, the opportunity cost of capital is an essential consideration in public economic evaluation. It forms the economic rationale behind discounting: a future dollar must be evaluated not in isolation, but in terms of what could have been earned had that dollar been invested or allocated differently today.
Boardman et al. (2018) emphasise that “the opportunity cost of an investment reflects the rate of return that society forgoes by committing resources to a specific project rather than the next best alternative.” In this sense, the discount rate used in CBA should approximate the social opportunity cost of capital, especially when the analysis is conducted from a societal or governmental perspective.
Opportunity cost also introduces an ethical dimension to discounting (Pearce et al., 2006). When evaluating long-term projects—such as those addressing climate change mitigation or social welfare programs (Stern, 2007), it is crucial to ask not only whether a project generates positive net benefits, but also whether it is the most efficient or equitable use of limited public funds. In this context, discounting based on opportunity cost ensures that future benefits are not artificially inflated and that resource allocation decisions remain grounded in economic efficiency.
📌Example
The Interplay Between TVM and Opportunity Cost
While distinct concepts, time value of money and opportunity cost, are interdependent in the discounting framework. The former explains why a future dollar is worth less today, while the latter helps quantify how much less it is worth, based on alternative uses of resources. Together, they form the theoretical justification for discounting and for the selection of an appropriate discount rate in economic evaluation (Pearce et al., 2006).
In essence, TVM provides the temporal logic for discounting, and opportunity cost provides its economic calibration.
📌Example: Discounting in a Highway Infrastructure Project
To better understand the practical importance of discounting in Cost-Benefit Analysis (CBA), consider a real-world scenario involving a major highway construction project undertaken by a national government.
The proposed project involves constructing a new expressway to reduce traffic congestion, improve travel times, and stimulate regional economic development. The initial capital cost of the project is $200 million, incurred in the first year. However, the majority of the benefits—such as fuel savings, reduced travel time, lower vehicle maintenance costs, fewer accidents, and improved economic productivity—are expected to accrue gradually over the next 30 years.
Why Discounting Matters in This Context
If planners were to simply sum up the nominal value of all future benefits without discounting, the project might appear highly profitable. For example, the estimated benefits over 30 years could sum to $600 million in nominal terms. However, those benefits do not carry the same economic value as if they were realised immediately.
By applying discounting, each year’s projected benefits are adjusted to reflect their present value—i.e., what those future benefits are worth in today’s terms. At a standard social discount rate of 5%, the present value of total benefits might reduce to around $320 million. The Net Present Value (NPV) would then be calculated as:
This NPV suggests that, even after adjusting for the time value of money, the project still offers a net gain of $120 million in economic value. However, had the discount rate been higher—say, 8%, the present value of benefits might fall to $250 million, reducing the NPV to $50 million, potentially making the project less attractive.
Implications for Decision-Making
This example clearly illustrates that the timing of costs and benefits matters deeply in economic evaluation. A project with high upfront costs and delayed benefits can appear economically unattractive if a high discount rate is used. This is particularly relevant for infrastructure projects, which typically have long-term payback horizons.
Moreover, this scenario shows how discounting ensures intertemporal comparability—allowing policymakers to make rational decisions across time by weighing the trade-offs between immediate expenditure and future social gains.
Policy Consideration:
If the government is pursuing broader goals such as regional development or intergenerational equity, it may decide to adopt a lower social discount rate, such as 3%, to better reflect the long-term societal value of infrastructure and avoid underinvestment in public goods that primarily benefit future populations.
3.2. Importance of Discounting the Future
Having established the theoretical underpinnings of discounting through the concepts of the time value of money and opportunity cost, this section turns to the practical and analytical significance of discounting within Cost-Benefit Analysis (CBA). In essence, discounting enables analysts and policymakers to compare costs and benefits that occur at different points in time by converting them into present value terms. This temporal alignment is crucial in ensuring the economic rationality of decisions, particularly in projects with long time horizons.
Why Discounting Is Essential in Cost-Benefit Analysis
Many public investments—such as infrastructure development, environmental conservation, and health system reforms—generate benefits that unfold over extended periods. Without discounting, these future benefits might appear disproportionately large in nominal terms, potentially leading to inefficient resource allocation. Discounting ensures that the timing of costs and benefits is appropriately factored into decision-making, thereby producing a more accurate and realistic economic valuation of a project or policy.
As Boardman et al. (2018) explain, “discounting ensures that resources are allocated in a way that maximises net social benefits across time, not just in aggregate nominal value.” In this way, discounting acts as both a financial adjustment tool and a policy-guiding mechanism that allows decision-makers to weigh short-term sacrifices against long-term gains.
Ensuring Intertemporal Comparability
One of the core functions of discounting is to ensure that costs and benefits incurred at different times can be fairly compared. This is particularly critical when evaluating multiple project alternatives that may have different timing structures for their returns. For instance, a project that delivers modest but immediate benefits may be preferable to a project offering large but distant returns, depending on how those future returns are valued through the discounting process.
In the absence of discounting, CBA could significantly overestimate the desirability of projects with heavily back-loaded benefits and underestimate the value of projects that deliver early returns. Discounting corrects for this by calibrating the timing of value realisation, thereby improving the credibility and comparability of policy evaluations (Pearce et al., 2006).
Preventing Bias in Project Appraisal
Discounting is also important to avoid systematic biases in public investment appraisal. Without it, projects that provide long-term social or environmental benefits may be overvalued in nominal terms and incorrectly prioritised, while short-term benefits might be underappreciated. Conversely, using a discount rate that is too high can unfairly penalise projects with long-term payoffs, such as climate change mitigation, early childhood education, or public health prevention programs.
In this way, discounting serves as a filtering mechanism that tempers nominal valuations with economic realism. It ensures that public resources are allocated toward projects that generate true net benefits when the timing of impacts is taken into account.
Enhancing Strategic Decision-Making
Discounting also supports more strategic, long-term decision-making. It allows policymakers to assess the trade-offs between present consumption and future investment, informing choices about whether to delay or accelerate action. For instance, governments evaluating whether to upgrade road infrastructure now or defer it for a decade must consider not just the raw cost and benefit values, but when those benefits materialise and how much they are worth today.
Similarly, in the context of fiscal planning, discounting helps ensure that investment decisions are aligned with macroeconomic conditions, including interest rates, inflation expectations, and debt servicing capacity. As such, discounting plays a crucial role in aligning project appraisal with broader economic strategy.
Applications in Practice
Discounting is commonly applied in various sectors, including:
- Infrastructure Projects – Evaluating the present value of time savings, reduced vehicle operating costs, and safety improvements from road or rail projects.
- Environmental Policy – Valuing future reductions in carbon emissions or biodiversity loss from conservation programs.
- Public Health Investments – Assessing the lifetime benefits of vaccination programs or disease prevention measures.
- Education Programs – Estimating long-term productivity and income gains from early childhood or higher education initiatives.
In each of these cases, discounting ensures that benefits realised many years in the future are not treated as if they were equivalent to benefits received immediately, thus enhancing the credibility and comparability of the analysis.
📌Example
A city plans to build a new public transit system that will provide substantial environmental and congestion relief benefits over the next 40 years. Without discounting, these long-term benefits might dominate the analysis and make the project seem overwhelmingly favourable. However, once the benefits are discounted to present value terms, they may appear more moderate—helping decision-makers more accurately weigh the investment against alternatives with shorter-term but certain benefits.
3.3. Choosing the Discount Rate in Cost-Benefit Analysis
While the rationale for discounting is well established, a key challenge in cost-benefit analysis (CBA) lies in selecting an appropriate discount rate. The choice of discount rate has a profound influence on the outcome of project appraisal, as it determines how heavily future benefits and costs are weighed relative to their present values. A higher discount rate reduces the present value of future flows, potentially undermining the case for long-term projects, while a lower rate gives more weight to distant impacts, often favouring sustainability and intergenerational equity.
We now explore the theoretical frameworks, practical considerations, and policy implications that inform discount rate selection in public and private sector decision-making.
Standard Approaches to Setting the Discount Rate
Market-Based Rates
In many applied settings, particularly within the public sector, governments use market interest rates as proxies for the appropriate discount rate. These may include:
- Government bond yields,
- Rates of return on private capital investments,
- Consumer interest rates.
The justification for using market rates lies in the concept of opportunity cost of capital—the return that could be earned if funds were invested elsewhere in the economy. Market rates thus reflect societal trade-offs between immediate consumption and deferred benefits. However, critics argue that market rates often overstate the social discount rate, particularly for projects with non-market benefits such as environmental protection or social welfare programs.
The Ramsey Rule
The Ramsey Rule offers a theoretically grounded approach to discounting from a social welfare perspective. Derived from intertemporal utility theory, the formula is expressed as:
💡Formula: Ramsey
Where:
- r = Social discount rate
- ρ = Pure rate of time preference (reflects impatience or preference for present utility)
- η = Elasticity of marginal utility of consumption (captures aversion to inequality)
- g = Expected growth rate of per capita consumption.
This approach integrates both ethical and economic dimensions into discount rate determination. It is widely used in climate change economics, most notably in the Stern Review (Stern, 2007), which advocated for a relatively low discount rate (~1.4%), arguing that future generations should not be heavily discounted simply due to the passage of time.
Factors Influencing the Choice of Discount Rate
Social Opportunity Cost of Capital (SOC)
The SOC approach defines the discount rate based on the rate of return that society could earn by investing capital in alternative uses. This reflects a productivity-based view of opportunity cost and is commonly used by finance ministries and planning agencies. It typically suggests rates between 6% and 8%, based on average returns to private sector investment.
However, while SOC is appropriate in capital-constrained economies, it may undervalue public investments that yield non-market benefits, such as health, education, or ecosystem services.
Social Time Preference Rate (STPR)
The Social Time Preference Rate is derived from the Ramsey Rule, which models society’s valuation of present versus future consumption. It incorporates both ethical and economic dimensions by accounting for time preference, expected consumption growth, and inequality aversion.
This approach often results in lower discount rates (typically 3–4%), making it well-suited for evaluating long-term public projects such as environmental protection, health, and education. Institutions like the World Bank, OECD, and UK Treasury commonly adopt STPR-based discounting in project appraisal. Importantly, STPR helps address intergenerational equity by ensuring that future benefits are not excessively devalued—an issue that can lead to systematic underinvestment in socially critical, forward-looking initiatives.
📌Example
The UK Treasury uses a base STPR of 3.5% for general project appraisal. However, for projects with intergenerational impacts—like carbon mitigation—the discount rate is reduced to 1.5% after 30 years, ensuring that long-term benefits to future generations are not excessively discounted. This practice reflects the ethical stance embedded in the STPR framework and encourages sustainable investment decisions.
Hyperbolic Discounting
Unlike the constant discount rate assumed in traditional models, hyperbolic discounting reflects behavioural economics research showing that individuals and societies tend to prefer smaller, sooner rewards over larger, later ones, but discount future outcomes less steeply over time (Frederick, et al., 2002).
💡 Formula: Hyperbolic Discounting
- PV = Present Value of a future benefit or cost
- Bt= Benefit or cost at time t
- t = Number of years into the future
- k = Hyperbolic discount rate (a constant capturing the degree of time preference)
This model has gained prominence in policy discussions, particularly around climate change, education, and health, where long-term investments are often undervalued under standard exponential discounting. Although not yet mainstream in CBA, hyperbolic discounting offers a more realistic representation of human decision-making behaviour and supports arguments for lower discount rates in intergenerational policy domains.
3.4. Impacts on Policy and Decision-Making
The choice of discount rate has far-reaching implications for public investment, economic planning, and ethical policy decisions. Below are key areas where discounting directly shapes outcomes:
Climate Change and Environmental Projects
Environmental projects often involve long-term, irreversible benefits—such as avoided carbon emissions, biodiversity protection, or water resource preservation. Applying higher discount rates can significantly diminish the present value of these benefits, making such projects appear less attractive in CBA, even when their societal value is substantial. As a result, many economists advocate using lower discount rates (e.g., 1–3%) for sustainability-related interventions (Stern, 2007; Pearce et al., 2006).
Intergenerational Equity
Discounting inherently involves value judgments about the importance of future well-being relative to present consumption. When discount rates are set too high, future generations are systematically undervalued, raising serious concerns about intergenerational equity and ethical fairness in public decision-making.
Lower discount rates help address this issue by giving appropriate weight to long-term social, environmental, and health impacts. They also reflect the normative view that governments should act as stewards of long-term societal welfare, not merely as agents of short-term cost minimisation.
📌 Example: Evaluating a Renewable Energy Investment Using Discount Rates
A local government is evaluating a proposed investment in a renewable energy project as part of its broader strategy to promote sustainable development and reduce carbon emissions. The project involves installing solar energy infrastructure to supply electricity to municipal facilities. In addition to the environmental benefits, the project is expected to reduce long-term energy costs and enhance local energy security.
To assess the financial viability of the project, the government applies Cost-Benefit Analysis (CBA) using the Net Present Value (NPV) method. Importantly, the analysis is conducted under two discount rate scenarios—3% and 7%—to illustrate the impact of discounting on the project’s economic attractiveness.
Financial Analysis
Project Details:
- Initial Investment (Year 0): $20,000
- Expected Future Cash Flow (Year 5): $30,000
- Project Duration: 5 years
To determine the present value of future benefits, the standard discounting formula is applied:
Where:
- PV = Present Value
- FV= Future Value of the cash flow ($30,000)
- r= Discount rate
- t= Number of years (5)
Scenario Analysis: Net Present Value Calculations
Scenario 1: Discount Rate = 3%
Scenario 2: Discount Rate = 7%
NPV Comparison of Renewable Energy Project at Different Discount Rates
| Scenario | Discount Rate | Future Cash Flow (Year 5) | Present Value (PV) | Initial Investment | Net Present Value (NPV) |
|---|---|---|---|---|---|
| Scenario 1: Lower Rate | 3% | $30,000 | $25,881.08 | $20,000 | $5,881.08 |
| Scenario 2: Higher Rate | 7% | $30,000 | $21,387.40 | $20,000 | $1,387.40 |
Interpretation and Implications
This case illustrates how the choice of discount rate significantly affects project evaluation outcomes. At a 3% discount rate, the project appears highly attractive, with an NPV of $5,881.08, indicating strong long-term returns. This lower rate reflects a greater emphasis on valuing future societal and environmental benefits, often used in sustainability-focused appraisals.
In contrast, using a 7% discount rate—which reflects a higher opportunity cost of capital or more conservative investment criteria—reduces the NPV to $1,387.40. Although still positive, the return appears less compelling, which could lead to the project being deprioritised in a competitive funding environment.
The contrast between the two scenarios demonstrates how discounting influences investment decision-making, particularly in public sector projects with long-term payoffs. Projects with delayed benefits are often more sensitive to higher discount rates, which may result in systematic underinvestment in sectors such as renewable energy, education, and health—unless lower discount rates are used to reflect long-term social value and intergenerational equity.
Policy Insight
Discount rate selection is not merely a technical choice—it reflects broader economic priorities, risk assessments, and ethical considerations. A lower discount rate strengthens the justification for investing in future-oriented public goods by ensuring that long-term benefits are not undervalued in present-day decision-making frameworks.
📝Key Takeaways
📚References
Boardman, A. E., Greenberg, D. H., Vining, A. R., & Weimer, D. L. (2018). Cost-benefit analysis: Concepts and practice (5th ed.). Cambridge University Press. https://students.aiu.edu/submissions/profiles/resources/onlineBook/E5V5H3_Cost-benefit%20analysis%20_%202018.pdf
Frederick, S., Loewenstein, G., & O’Donoghue, T. (2002). Time discounting and time preference: A critical review. Journal of Economic Literature, 40(2), 351–401. https://doi.org/10.1257/002205102320161311
Mishan, E. J., & Quah, E. (2020). Cost-benefit analysis (6th ed.). Routledge. https://doi.org/10.4324/9781351029780
Pearce, D., Atkinson, G., & Mourato, S. (2006). Cost-benefit analysis and the environment: Recent developments. OECD Publishing. https://doi.org/10.1787/9789264010055-en
Stern, N. (2007). The economics of climate change: The Stern review. Cambridge University Press. https://assets.cambridge.org/97805217/00801/frontmatter/9780521700801_frontmatter.pdf
The current worth of a future sum of money or stream of benefits/costs discounted to today’s terms.
The rate used to convert future values to present terms, reflecting time preference and opportunity cost.
The tendency to prefer immediate benefits over future ones, forming the basis for discounting in CBA.
The return society sacrifices when allocating capital to public projects instead of private investments.
The distribution of resources among competing uses to maximize social returns.
A fairness principle ensuring that future generations’ needs are accounted for in present-day decision-making.
A financial principle stating that money has greater value now than in the future due to its earning potential and opportunity cost.
The value of the best alternative forgone when a resource is committed to a project.
