Time and Discounting in Private and Public Decision Making
Edited by David J. Pannell and Steven G.M. Schilizzi
Chapter 4: Compounding and Discounting Under Risk: Net Present Values and Real Option Values
Greg Hertzler SUMMARY After a century of promoting benefit–cost analysis using net present values, some economists have lost faith. A net present value discounts the long-term consequences of species extinctions, greenhouse gas emissions and nuclear wastes to virtually nothing. This is unacceptable. Several studies have tried to salvage net present values by adjusting the discount rate. This study argues that adjusting the discount rate will lead to even worse consequences. It argues, instead, for a more general method: real option values. Real option values generalize net present values to include random variables, nonlinearities and irreversibilities. An example shows that the real option value of damage to the environment can be many times higher than the net present value and several times higher than the expected damage, itself. In a world of uncertainty, real option values should replace net present values in all benefit–cost analyses. Then we may adequately value our future. 4.1 INTRODUCTION If you were asked to nominate the most useful idea in economics what would it be? For many people, all those marginal concepts seem to be, well, marginal. For some, one big idea stands out: making sound investment decisions. The traditional criterion for evaluating an investment is its net present value. The calculation is simple. Discount future benefits back to the present and subtract the costs. If the result is positive, an investment is good. Good investments are how wealth is created and standards of living rise. 37 38 Economics and the Future Many economists...