Abstract
It is widely recognized that the evaluation of risky projects critically depends on how the riskiness of future benefits is treated. Standard discounting theories are based on the assumption that risks that are uncorrelated with aggregate risk are diversified, so that projects’ idiosyncratic risk is not priced. However, this may not be true for long-term risky projects, such as those with persistent idiosyncratic shocks. In this study, we investigate the impact of both aggregate risk and nondiversifiable idiosyncratic risk on the discount rate for risky projects. We extend the generalized discount rate to the case of persistent shocks. A particular advantage of the generalized discount rate is that it can be applied in the setting of incomplete markets. We show that nondiversifiable idiosyncratic risk reduces the discount rate, and increases the present value of projects’ future uncertain benefits. We further apply our findings to the evaluation of emissions reduction projects.
Highlights
The choice of an appropriate discount rate is a critical and contentious issue in environmental and resource economics, as it determines whether a project passes the cost-benefit test
Our numerical application implies that the discount rate for risky projects is overestimated and the present value (PV) of emissions reduction benefits is underestimated when ignoring the impact of the nondiversifiable idiosyncratic risk
We incorporate the persistent shocks of the consumption growth and the project’s productivity rates into our model, and further investigate the term structure of the generalized discount rate (GDR)
Summary
The choice of an appropriate discount rate is a critical and contentious issue in environmental and resource economics, as it determines whether a project passes the cost-benefit test. Both aggregate risk and nondiversifiable idiosyncratic risk on the discount rate for risky projects. We assume that risky projects’ benefits are affected by both uncertainties of consumption growth and project productivity. Our numerical application implies that the discount rate for risky projects is overestimated and the present value (PV) of emissions reduction benefits is underestimated when ignoring the impact of the nondiversifiable idiosyncratic risk. Our study is closely related to the risk-adjusted discount rate (RADR) literature on evaluating risky projects (Gollier 2014, 2016b; Dietz et al 2018). Weitzman (2013) states that the idiosyncratic risk of a long-term risky project with environmental impacts should be priced.
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