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Risk-adjusted Social Discount Rates

Abstract:
When evaluating public and private investment projects, those that contribute more to the collective risk should be more penalized through an upward adjustment of their discount rate. This paper shows how to estimate the risk-adjusted discount rate for different projects, with applications to the electricity sector. Using the standard framework of consumer theory, we express any investment project's beta in terms of the easier-to-measure price and income elasticities of the goods generated by the project. When considering an investment in production capacity, the beta has a flat term structure, and is positive (negative) for normal (inferior) goods. When considering core infrastructures carrying goods or services, such as energy transmission and distribution assets, the beta has a decreasing term structure with very high values at short horizons for infrastructures facing capacity constraints. We provide a real-case example of a cross-border electricity connection with negative beta for the exporting country.

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Keywords: Investment theory, Risk-adjusted discount rate, Public investment, Electricity transmission, Capacity investment, Cross-border transmission network

DOI: 10.5547/01956574.43.4.fche

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Published in Volume 43, Number 4 of the bi-monthly journal of the IAEE's Energy Economics Education Foundation.

 

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