Discount Rate Basics
Prerequisites
A dollar received ten years from now is worth less than a dollar today. How much less depends on the discount rate, and in energy project evaluation, the choice of discount rate can flip the ranking of competing technologies.
The discount rate converts future cash flows to present value, reflecting two factors: the time value of money (a dollar today can be invested and grow) and risk (future payments are uncertain). A higher discount rate shrinks the present value of future costs and benefits more aggressively. The formula: present value = future value / (1 + r)^n, where r is the discount rate and n is years in the future.
Apply to a payment. $1 million received in 10 years. At 3% discount rate: PV = $1M / (1.03)^10 = $744,000. At 10% discount rate: PV = $1M / (1.10)^10 = $386,000. Same payment, half the value at the higher rate.
Connect to energy. Power plants live for decades, so nearly every energy investment decision is a present-value calculation in disguise.
A pension fund is offered $1 million in 10 years or $500,000 today. At roughly which discount rate is it indifferent?
Just above 7%. At 7.2%, $1 million in 10 years is worth $500,000 today (1.072^10 is almost exactly 2). Below that rate, take the future million; above it, take the cash now. Every energy investment embeds this same comparison, usually with someone's assumption doing the choosing quietly.
The next lesson shows how far this one spreadsheet cell can move the answer: the same power plant can look cheap or expensive on the discount rate alone.
A 10% discount rate is applied instead of a 3% rate to evaluate a nuclear plant with $10 billion upfront cost and 60-year lifetime. The effect is:
High discount rates devalue future output. A capital-intensive plant with 60 years of production sees most of that output heavily discounted, while the large upfront cost is fully counted at present value.
The answer is CLesson complete
Next: Capital Intensity Bias→