What do Suburban Rail Loop, Inland Rail, and East Coast High Speed Rail have in common? Yes, they’re all rail; yes, they’re all massive; but what’s really distinctive is that all three have business cases assessed with a lenient 4 per cent discount rate rather than the standard 7 per cent.
While it’s true that Australian governments generally don’t do a great job of setting discount rates, it’s also true that cherry-picking favourable rates for particular projects just makes the situation worse. What’s needed is a total overhaul.
Discounting may seem an arcane idea, but governments must be able to compare one project with another, by putting costs and benefits that occur at different points in time on an equivalent footing.
The underlying framework that Australian governments use to rationalise their discount rates is to reflect the next-best use of the resources for that project, and with the same level of risk. The next-best project could be in the transport portfolio, in another portfolio, or even a financial investment overseas with the same level of risk.
The type of risk that matters for discounting is the sensitivity of a project’s expected returns to the economy generally – the systematic risk. Most government transport infrastructure is still used whether the economy is booming or in the doldrums, because most people keep on travelling to work or school, and buying transported goods. Using a single discount rate for government transport investments may not be perfect, but it is simple, transparent, and difficult to manipulate.
What else do these three projects have in common? They’re all controversial. In each case, a lenient discount rate has made a huge contribution to presenting a positive appraisal of the project.
Discount rate makes a difference
Suburban Rail Loop is the Victorian government’s signature infrastructure project, and the single most significant point of difference with the opposition heading into this week’s election. The government’s business case uses a discount rate of 4 per cent, and includes a range of non-conventional benefits; on this basis, the project would have benefits of $1.10 to $1.70 for every dollar spent. But with all the same assumptions, except reverting to the standard 7 per cent discount rate, the project would return benefits to the community of just 77¢ for every dollar spent, according to the auditor-general.
Inland Rail remains a signature project of the Nationals, and is currently under a review commissioned by federal Infrastructure Minister Catherine King. The 2015 business case used a discount rate of 4 per cent; on this basis, the project would have returned benefits of $2.62 for every dollar spent. But with the same assumptions, except using a standard 7 per cent discount rate, the benefits would be a skinny $1.10 of value for every dollar spent. And that’s before you take account of the fact that the cost of the project has gone up a further 50 per cent since the 2015 business case, from $9.9 billion to $15.4 billion, so far.
East Coast High Speed Rail is a signature project of federal Labor, pursued when in office in 2013 and revitalised now with the creation of a High Speed Rail Authority and $500 million to kickstart the project.
The 2013 feasibility study used a discount rate of 4 per cent; on this basis, it found the project would return $2.30 of value for every dollar spent. But with a 7 per cent discount rate, the benefits would be a slender $1.10 per dollar spent. And that’s for a route that cuts costs by not offering a commuter service for routes such as Newcastle to Sydney or Wollongong to Sydney, and that predates the decision to build the Western Sydney Airport.
It is true that a discount rate of 7 per cent is far too high when the cost of money is low by historical standards. Indeed, Grattan Institute has been arguing this case since 2018. But nonetheless this penalty remains in place for all projects. Any major infrastructure project should be assessed in accordance with established practice, and subject to the same constraints as rival projects with similar levels of risk.
Australia needs a level playing field for all the projects and investments clamouring for public money. The federal government should establish an authoritative, evidence-based approach to setting discount rates, updated annually to reflect changes in the expected risk-free rate (or, as a proxy, the 10-year Commonwealth bond yield).
Fixing discount rates won’t be enough on its own, though; Australia should also tackle the broader quality of project appraisal. The best idea on the table is to permit federal funds to be spent on infrastructure projects only if the cost-benefit analysis has been assessed and the project ranked by Infrastructure Australia – a great innovation proposed in 2014 by none other than the then opposition spokesman, Anthony Albanese.
What about it, Mr Prime Minister?
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