As explained previously, the discount rate reflects the rate at which people are willing to exchange present and future economic benefits. According to standard economic reasoning, discount rates are revealed by people’s observed behavior in markets for savings and investment. A homeowner who takes out a loan at a 4% real (inflation-adjusted) interest rate, for example, reveals a willingness to pay back $3.24 30 years from the present to obtain just $1 dollar today. Similarly, a worker who invests $1 in a mutual fund would expect to receive $10.06 upon retiring three decades in the future given an 8% annual return.
Economists generally agree that market rates of return reveal people’s discount rates. It is important to note, however, that different types of financial assets yield different rates of return. In particular, safe investments, such as money market funds, certificates of deposit, and short-term government bonds, yield real returns on the order of just 1% per year. Risky assets such as corporate stocks, in contrast, pay average real returns of 6% or more on a long-term basis. The high returns paid by stocks constitute a risk premium that rewards investors for accepting the fluctuations associated with financial markets.
If households and businesses were well informed and rational, then economic theory suggests that they would discount the benefits of energy-efficient technologies at a rate equal to the market return available on investments with similar risk. In general, the volatility of energy prices implies that the benefits of energy efficiency are uncertain. On the other hand, investments in energy efficiency reduce people’s vulnerability to large swings in energy prices. In this sense, energy efficiency measures have ambiguous effects on the overall financial risk faced by households and businesses. In practical analysis, it is common to assume that investments in energy efficiency have risk characteristics similar to those associated with typical private sector investments. In theoretical terms, this assumption favors the use of a 6% discount rate.
Despite this body of theory, empirical studies have found that people behave as if they discounted benefits of energy-efficient technologies at an annual rate far in excess of 6% per year. An early study by Hausman, for example, suggested that people discounted the energy savings provided by air conditioners at a 25% annual rate. Later studies summarized by Train and Ruderman et al. pointed to the existence of implicit discount rates ranging from 25% to 300% for refrigerators, heating and cooling systems, building shell improvements, and a variety of other technologies. These studies employ sophisticated econometric and/or engineering-economic models to gauge the rate of time preference at which people’s actual technology choices could be considered economically rational. As noted by Howarth and Sanstad, the fact that people reject efficiency technologies that yield high rates of return suggests that actual behavior may diverge from the assumption of perfect rationality.
Analysts such as Hassett and Metcalf have attempted to explain this anomaly by arguing that improvements in the state of technology over time can provide a reason to defer investing in technologies that are apparently cost-effective in the short term. The reason is that purchasing an item such as a fuel-efficient car implicitly raises the cost of buying an even more efficient vehicle a few years later. To better understand this point, consider the case of a mid-1990s computer user weighing the merits of purchasing an upgraded machine. For a cost of $2000, the user could step up from a good system to a very good system with enhanced speed and performance. Alternatively, the user could defer the purchase for 1 or 2 years and expect to buy a far better machine for an equal or lower price. Hassett and Metcalf reasoned that this type of behavior could explain the high discount rates revealed in markets for investments in energy efficiency.
According to this perspective, the benefits of waiting imply that the early adoption of energy – efficient technologies may have a type of hidden cost (or option value) that is sometimes ignored in naive technology cost studies. An empirical analysis by Sanstad et al., however, suggests that the magnitude of this effect is too small to have much impact on decisions about energy efficiency given anticipated developments in energy prices and the pace of technological change. This line of reasoning therefore appears not to explain why technologies that yield positive discounted net benefits or (equivalently) attractive rates of return are often passed up in markets for energy-using equipment.