95 Climate change, interest rates and Taylor Swift

This episode of the blog was sparked by a LinkedIn post on climate change and uncertainty.?

“You have actually more certainty about the trajectory between now and 2030 of climate impact, then you do the path of interest rates, or inflation, or AI or who Taylor Swift will be dating.”

I hadn’t realised that Taylor Swift was quite such an influence on everyday life, but in the same week there was a headline in the Guardian newspaper.

“Will the Taylor tour spur inflation? No, but a Swift spending spree might just save us from a recession”.

I will come back to how we should consider the activities of Taylor Swift in drainage planning later, but, for now, let’s talk about interest rates.

Interest rates and drainage planning

So, why are interest rates important for drainage and wastewater management plans?? Very simply, if interest rates are low then it is worthwhile borrowing money to invest in drainage assets that will reduce the future costs to the utility, to the environment or to society.

If interest rates are high then you want to avoid borrowing money to invest in the future and will instead choose to accept ongoing costs; either opex spend or the impact of failure.

Strictly speaking, what matters is the difference between interest rates and inflation.? This is called the discount rate.

If inflation is higher than the interest rate then it is even worth borrowing lots of money to buy things that you don’t actually need and then sell them at the inflated price in a year’s time.? The cost of borrowing is less than the increase in price so overall you make money.? Of course you should only buy things that will not perish and that are cheap to store.

If interest rates are higher than inflation then doing this would lose money.? Instead you want to reduce expenditure and even sell things that you don’t currently need to put money into savings to earn interest.? The interest that you earn will outpace inflation so that you can buy things back in a year’s time and still be in profit.

Use of discount rate

To assess investment schemes we use the discount rate to assess the Present Value of costs and benefits.?

Present value is calculated as:

Were:

• Value(n) equals the value of a cost or benefit incurred n years into the future in today’s money
• DR is the discount rate

We sum up all of the present value of benefits and subtract all of the present value of costs to give the Net Present Value.? If it is positive then the scheme is good value; if it is negative then it is bad value.

A neat trick for ongoing costs or benefits that have the same value each year is that we can quickly calculate the present value of the whole stream of values as:

For a discount rate of 3.5% this gives the total present value of the ongoing future cost or benefit as 27 times the annual value.

Selection of discount rate

If we are considering the discount rate for investing in long term assets or in a rolling programme of investment then we need the long term average discount rate as this will be the long term cost of funding the investment.?

This section is specific to the UK (in fact England and Wales for some parts) but similar values are probably appropriate elsewhere.

Treasury Green Book

The “Green Book” published by the Treasury of the UK Government sets out the rules for all investment in public services.? It recommends that costs and benefits occurring in the first 30 years should be discounted at an annual rate of 3.5% with a schedule of declining discount rates after that.? There is additional guidance for investments that have very long effects, in excess of 50 years, and that involve irreversible wealth transfers between generations.? This could be appropriate for a scheme such as the Thames Tideway Tunnel that will last for hundreds of years.

Ofwat WACC

Ofwat (the economic regulator for the England and Wales water companies) sets out a standard Weighted Average Cost of Capital (WACC) that is intended for long term planning but that is updated every 5 years.

In January 2014, Ofwat set out its assessment of the industry wide cost of capital estimate for PR14. The weighted average cost of capital (WACC) set out by Ofwat was 3.70% at the wholesale level.

This WACC is based on a weighted average between the cost of debt financing and the cost of equity financing.

In January 2014 the value was set at 3.7% based on a notional target of 62.5% debt at a cost of 2.75% and 37.5% equity at a cost of 5.65%.

This is therefore similar to the Treasury Green Book value and so the Ofwat guidance and the Treasury guidance therefore both lead to very similar assessments.

However, the definition of both sets of values seems to be for an interest rate rather than then subtracting inflation to give a discount rate.? For the government inflation target of 2% this value of WACC would seem to give a discount rate of only 1.7%.

Historical trends

I did a quick web search for how this guidance for long term discount rates matches up with historical data.? I found this interesting article that looked at UK and US discount rates over the last hundred years.? Remember this is discount rates so the difference between interest rates and inflation.

Interestingly, real discount rates were negative for about a third of the time sometimes substantially so.? Overall the estimated long term discount rate was 1.7% for the UK and 2.2% for the US.

If this is correct then we should be using a lower discount rate for assessing investment and so investing much more in our drainage and wastewater systems and indeed in other public assets.? That would be a nice idea.

So, although there may be considerable uncertainty over interest rates, there isn’t over discount rates and those are the ones that matter.

Short term issues

Long term discount rates are appropriate for assessing whether or not to invest, but we also need to consider the impact of short term fluctuations in interest rates, inflation and therefore discount rates.

For a heavily indebted company a short term rise in interest rates will mean that interest on the debt financing will increase and will need to be paid.? This cannot be paid for by reversing the investment.? We cannot unbuild something to get the money back to pay off the loan.? It is therefore necessary to have reserves or alternative financing in place to cover these short term issues and pay back when discount rates are lower.

DWMPs and Taylor Swift

So do we need to consider Taylor Swift album release dates and tour schedules in our adaptive planning process for long term Drainage and Wastewater Management Plans?? I am struggling to find a connection, but this web page does.? “Ranking the tracks of ‘1989 (Taylor’s Version)’ based solely on their connection to sewer infrastructure. ?A totally normal thing to do. ”