Benefit-Cost Analysis and the Discount Rate for the Corps of Engineers' Water Resource Projects: Theory and Practice

Publication Date: June 2003

Publisher: Library of Congress. Congressional Research Service

Author(s):

Research Area: Environment

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Abstract:

Construction of large water resource projects, such as those of the Army Corps of Engineers (Corps), can be controversial because they involve trade-offs among various river uses, and between current and future generations. Pursuant to federal water project planning guidelines, the Corps weighs these trade-offs using benefitcost analysis. If its analysis shows that a project's national economic development (NED) benefits exceed its NED costs, the Corps seeks project authorization from Congress. Congress authorizes the Corps to construct some of these large water projects through (usually) biennial Water Resource Development Acts. Since the Corps rarely recommends a project that does not have a benefit-cost ratio greater than 1.0, this report describes the decisions that influence this ratio, with a focus on the role of the discount rate.

One of the decisions that critically influence the outcome of a benefit-cost ratio is the choice of a discount rate to transform future benefits and costs into present values. The Corps uses a discount rate formula established in the Water Resources Development Act of 1974. This formula bases the discount rate on the average yield of long-term government securities. Some economists, however, argue that the rate should reflect the cost of displacing private investment, specifically the rate of return on capital in private markets, which is usually higher than long-term government securities.

Due to the temporal distribution of water projects' benefits and costs (e.g., large near-term costs and with benefits typically distributed over very long time periods), projects evaluated with a lower discount rate are more likely to pass the benefit-cost ratio test than projects evaluated using a higher rate. Since the Treasury rate is generally lower than the rate of return on private investments, changing the water project rate (now 5.875%) to a rate of return closer to that on private investments, such as the OMB's base rate (now 7%), would likely decrease the number of projects that have a benefit-cost ratio of greater than 1.0.

Basing the water project rate on Treasury rather than private-sector rates is not the only controversial component of the discount rate formula. For example, the Corps calculates future benefits and costs using real dollars (i.e., inflation is removed from these figures), but discounts using a nominal discount rate (i.e., one that is not corrected for inflation to produce a "real" rate). This underestimates the present value of future benefits and costs and reduces the likelihood that long-term projects would pass the benefit-cost ratio test. Notwithstanding this technical inconsistency, there are other issues associated with the Corps discount rate formula: use of an average rather than a marginal rate of return, use of a rate based on long-term rather than shorter-term securities, and use of the yield rate rather than the coupon rate. Given the many factors that influence the discount rate, the net effect is unknown. In addition, many factors other than the discount rate affect the benefit-cost ratio and project recommendations, but are beyond the scope of this report. This is a background report and is unlikely to be updated.