by Anna Chau, Acting Chief Executive, Infrastructure Australia
The quality of Australia’s future infrastructure could be at risk if we heed calls to shake-up the way infrastructure projects are selected.
Last week, the House of Representatives Standing Committee on Infrastructure, Transport and Cities’ released a report on the Australian Government’s role in the development of cities, which recommended lowering the discount rate for major infrastructure projects from seven to four per cent.
While we welcome efforts to improve transport infrastructure selection processes, this proposal is misplaced and should be abandoned.
Discounting is an important part of the cost–benefit analysis of infrastructure projects. Discounting refers to when we adjust the values of future costs and benefits so we can compare them on an equal footing with those in the present. This is necessary because the future is uncertain.
Since infrastructure projects tend to have high capital costs and long benefits out into the future, the discount rate helps us understand which projects are more valuable than others.
Changing the discount rate, however, won’t make this process any more rigorous. On the contrary, it will lower the bar by allowing more subpar projects through the gate. Lowering the discount rate is like lowering the passing grade from 50 per cent to 25 per cent. We wouldn’t do this for kids in our schools, just as we wouldn’t lower the standards in our hospitals, so why should we do it for our major infrastructure projects?
Part of the reason this proposal has gained attention in recent days stems from the view that the discount rate should move in ‘lock step’ with the 10-year Australian Government Bond Yield, a measure used to represent what is known as a risk-free rate. This rate is a theoretical rate of return on an investment with zero risk. At the moment, this sits at around three per cent.
But infrastructure projects are not risk-free. Quite the opposite in the case of many transport projects. So the risk-free rate should make up only one component. That is why Infrastructure Australia applies a rate of seven per cent when evaluating project business cases, to take into account a range of future costs and risks. This protects Australian taxpayers by helping governments make smart investment decisions with their money.
Absolutely, if we just applied a lower discount rate – or even the risk-free-rate – many infrastructure projects would look more attractive, because future benefit streams would appear much higher.
The problem with this thinking is that changing the discount rate does not change the amount of public funding available for projects. The pot of government money for infrastructure does not change with the discount rate. It depends on the health of the government’s coffers and its appetite for borrowing.
Changing the rate also doesn’t increase the amount of private financing available. Private investors will invest money based on their risk appetite and rate-of-return targets. A lower discount rate isn’t likely to help a project with a lower social return attract more private sector financing.
In Australia, we have never had a problem with the number of high quality projects in the infrastructure pipeline, so why lower the bar and risk misallocating funds to projects that don’t pass muster?
If we change the discount rate, we risk saddling the economy with C-grade investments. It could lock the country into projects with lower productivity improvements, which means our economy is worse off in the long run.
Crucially, it would also mean that future generations are deprived of projects with higher productivity payoffs. This is a form of intergenerational theft.
That’s why we think politicians and the private sector should rethink this proposal. Let’s make sure the bar for infrastructure projects stays high, so we all benefit from quality infrastructure now and into the future.