Discount Rate

A Discount Rate can be defined as an interest rate used in discounted cash flow analysis to calculate the present value of future cash flows. That sounds a bit complicated if you aren’t financially-minded, but in effect it’s a factor used to reduce the perceived value of future money (be that costs or revenues).

Assuming an discount rate of 0% would mean that if I gave you £1000 in a year’s time, it would be worth just as much to you as if I gave it to you now. In practice, I imagine you’d rather have it now! That might be because you don’t trust me to reappear in a year’s time, but there’s also a sound financial reason: if I gave you £1000 now, you might hope to generate an annual return on it, say 10%. In which case you’d end up with more money (£1100) in a year’s time. Or, put another way, £1100 received in a year’s time, discounted at a rate of 10%, has a present value of £1000. You could look further forward too: another 10% return on your £1100 would mean you had £1210 after two years, from your initial £1000 investment. So the present value of £1210 received in two year’s time, discounted at an annual rate of 10%, is also £1000. And so on: the further forward you look and the higher the discount rate, the less valuable that future money looks in today’s terms.

The same approach can be applied to revenues generated (and costs incurred) for an energy project: the further into the future they occur and the higher the discount rate used, the lower these financial quantities look in terms of present day value. For example, the costs of decommissioning a nuclear power plant now are extremely high, but in the financial model of a new project these may occur 50 years into the future. Apply a discount rate to those future costs and their present value will look much, much smaller.

Probably the most common reason the non-financially minded might need to be aware of discount rates in the energy business is because any calculation of levelised cost of energy (LCOE) must assume one. As you can imagine from the description above, choosing a different discount rate can have a significant impact on the LCOE that’s calculated from the same project data.