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I , ,. adjusted annually and is based on long-term Treasury Bond rates averaged over the previous 22 months. This designated discount rate is provided in the annual supplementto NIST Handbook 135,Energy Prices and Discount Factors for Life-Qcle Cosl Analysis 1995. If one of the primary purposes of the federal project includes conservation or renewables, the handbook recommends use of a real discount rate of 3.0% and a nominal discount rate of 6.6% (Petersen 1994). In the private sector, there are no guidelines as to the appropriate discount rate to use for evaluation. As such,sensitivityanalysisisrecommendedwithrespecttothediscountrate. Sensitivityanalysisshowsthe variation in fhe cost or benefit measure as the values of input variables, such as the discount rate change. The subject of sensitivity analysis is covered in the Unce&iinty and Risk subsection in Section 2. For the commercial and industrial sectors, most experts recommend a discount rate equal to the opportunity cost of capital. The opportunity cost of capital is the rate of return on the best alternative investmentavailable. Unfortunately,thesedataarenotreadilyavailableandvaryforeachinvestorand investment. Another measure frequently employed to estimate a discount rate is the cost of capital (the average cost of capital is widely used but the marginal cost of capital is preferred; see the Cost of Capital subsection inSection2). Hereagain,thecostofcapitalvariesfromoneinvestorandinvestmenttoanother,which limitsitsusefulnessasaproxyforageneraldiscountrate. However,itispossibletoexaminetheaverage cost of capital to U.S. industry from 1976 to 1989. As calculated in Appendix C, this average cost of capital (based on historical returns to equity investors m d after-tax interest paid on debt) is approximately 5% real (or 7% real be€ore-taxes)! Although these historical averages represent the actual average returns to investors, it should not be assumed that the historical returns represent the “hurdle“rate (or discount rate) used by investors to decide whether or not to undertake a specific project. Many investors in the private sector will be seeking a greaterthanaveragereturn. And,ofcourse,manyinvestmentscarryahigherthanaveragerisk,dictating agreaterpromisedreturnbeforetheprojectwillbeundertaken. Ontheotherhand,therearedsomany whotakealessthanaveragereturn(i.e.,theyinvestinT-Billsandlowerriskbonds). Intheabsenceof statistical data on discount rates used by industrial, txansportation, and commercial investors for investments with risks similar to those of conservation and renewable energy investments, it is recommended that a real after-tax discount rate of 10% (add in expected inflation to estimate a nominal discount rate) be used within the Office of Energy Efficiency and Renewable Energy for these sectors. Of course, if the analysis concerm a specific investor, the discount rate should be based on the investor’s opportunity cost of capital for investments of similar riskiness. In the residential sector, the cost of capital may not accurately represent actual discounting behavior. Residential customers weigh the opportunity cost of capital much greater than financial markets require (EPRI 1987). Recall that the opportunity cost of capital is the rate of return needed to induce investors to invest in a project of similar risk and duration. The residential sector seems to require a much higher rate of return on an investment than financial markets require. Possible explanations for this include uncertainty, short residency period (investment period), availability of capital, income, and noneconomic factors. Perhaps a homeowner does not know how much longer he or she will live at a present address, or a renter does not wish to invest in something that cannot be taken when he or she leaves. Hausman (1979), using data on the purchases of new air conditioners, calculated discount rates that households use 4Theafter-taxinterestrateassumesthatthehighestmarginaltaxrateispaidbyindustry. Inreality, however, the actual rate paid is frequently less, making the actual historical real returns to investors, after taxes, somewhere between 5.0% and 7.0%. 7PDF Image | A Manual for the Economic Evaluation of Energy Efficiency and Renewable Energy Technologies
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