Despite our technological achievements, decisions that affect future generations are still based on arcane financial models that artificially make future global risks such as climate change and pandemics vanishing small failing to appropriately value collective actions that we could take today to alleviate such risks. The current pandemic provides grim evidence of this issue. By grossly underestimating future global risks, such financial models understate the long-term effects of today’s actions imposing a cost on future generations that the current one has little incentive to fix. Although history shows there is no limit to human ingenuity for technological innovation; sadly, it will not be technical limitations that inhibits society’s response to the great challenges posed by global risks, but rather flaws in the financial models used to make long-term consequential decisions. These arcane financial models, developed in a different time under a different set of circumstances have promoted the old-adage “time is money,” that captures both western civilization’s fascination with material wealth and its current short-term decision-making mindset. Continued reliance on these outdated models hampers our ability to fund projects with long-term benefits that reduce such global risk impacts. We need to start acknowledging that time is not money; risk is! A practical financial model that captures precisely that is described herein: the decoupled net present value (DNPV).
As financial markets blossomed in the early 20th century, the need to compare simple investment instruments such as bonds with different maturities and default risks arose, sparking the development of the discounted cash flow (DCF) concept which relies on discount rates to set cash streams that take place at different times on equal temporal footing. To achieve the comparison of investment instruments, the analysis commingled payment risk (i.e., default) with the time value of money to determine discount rates. Higher discount rates were used to account for higher default risks. When later extended to perform cost benefit analysis of more complex investment opportunities, DCF models failed to accommodate detailed cash flow risk profiles. Nonetheless, DCF kept the idea of comingling risk and time value of money. As a result, the mechanics of DCF analyses breed the incorrect perception that short-term benefits are always more valuable (or liabilities more harmful) than long-term ones reinforcing the “time is money” concept. This implicitly and effectively transfers costs and risks from current to future generations while siphoning wealth from those generations to the present, thereby hampering our ability to finance promising adaptation ideas within appropriate timeframes. The impact of the distortion introduced by discounting future revenues and/or liabilities on economic policy development and/or public investments in the energy sector have been clearly exposed in early publications. Unfortunately, nearly four decades later, the issue of discounting is still widely prevalent today among practitioners and academics alike as clearly illustrated in a recent article on climate-change risks of global financial assets. In there, the authors recommend using discount rates given by the opportunity cost of capital of private investors when valuing a portfolio of privately held financial assets.
Climate change is a global risk that provides a stark example of this adaptation logjam. There is broad consensus among the scientific and regulatory communities that the physical impacts of climate change resulting from unchecked anthropogenic activity will not only increase the risk of losses in coming decades but also the magnitude of the effect2,. However, the inability of DCF to consistently and transparently monetize the effects of physical risks on long-term asset value discourages investments in the scientific and engineering advances that could provide more sustainable solutions to our most challenging problems at a fraction of the cost. In a nut shell, for typical discount rates used in standard financial analysis, DCF promotes the idea that $1 saved today is far more valuable than $6 of avoided future costs, making it difficult to make the case that society at large is better served investing its financial resources today in resilience and adaptation.
2.0 Short-termism and the Tragedy of the Horizon
Promoting and adopting sustainable solutions requires all stakeholders, including non-profit and for-profit executives and shareholders, elected officials, and the community in general, to adopt a long-term mindset so that investments in sustainability or resilience are not perceived as a gamble that only pays off in the event of a disaster. Although nobody would label wasteful an individual buying health or life insurance while hoping at the same time to never use it, the same cannot be said when evaluating the well-being of a community. Unfortunately, acting against the need to implement longer-term investment strategies is the mismatch between the horizons of those typically charged with executing the ideas (e.g., executives who typically have short-term horizons and reduced exposure to long-term impacts) and those affected by them (e.g., communities who suffer most from long-term impacts yet often have little influence over decisions). This misalignment invariably results in myopic investment strategies that favor projects offering faster returns over those that would increase long-term shareholder and social value,. This widespread bias favoring short-term investment decisions has led to a phenomenon known as the Tragedy of the Horizon in which the consequences of decisions are felt well beyond the short-term horizons of business/political cycles and often impose a significant burden not only on the current but also on future generations (Figure 1). Although the term was originally introduced to describe the concerns associated with climate change risk, the same is true for other major global risks facing society.
The Tragedy of the Horizon is exacerbated by the widespread use of DCF techniques to perform cost benefit analysis of long-term investments, since this results in severe economic distortions and promotion of perverse incentives in which future value is underemphasized. As a result, although society can save $6 in future disasters costs for every dollar spent on hazard mitigation, more often than not, such investments are difficult to justify financially and therefore postponed or worse yet, supported by the artifact of discounting, available funds are invested in alternative less-promising technologies. At the heart of DCF techniques is the process of exponentially reducing the value of future revenues (or expenses) to express their net present value (NPV) in today’s currency so that revenues/costs taking place at different times can be easily, albeit incorrectly, compared. Future values become exponentially smaller as increasingly higher discount rates are selected further favoring short-termism. If discount rates are increased to accommodate the cost of capital of private investors, they may obtain an unfair compensation for risks that have been cleverly negotiated and transferred to future generations.
Table 1: Discounting the Future. The present value of $6000 at different times (t) discounted at different rates (real).
Since investment risks and discount rates are loosely connected, if at all, there is no standard systematic approach describing how discount rates should be calculated to account for different risks. As a result, rates are largely prescribed rather than calculated. The practice of using discount rates as a proxy for risk and comparing the return on investment to the risk-free return on safe investments such as U.S. Treasury bonds has the unfortunate effect of commingling two very distinct parameters: the time value of money and risk. This practice has reinforced the widely popular concept known as “time is money” which has been used to evaluate not only the performance of private investments but also non-profit institutions exhorting foundations to distribute their assets at a faster rate.Consider a 7% discount rate net of inflation (the rate recommended by the Office of Management and Budget to be used by U.S. federal agencies) applied to a 60-year period (two generations). Application of a 7% discount rate renders the present value of final revenues/expenses at less than 2% (i.e., $104/$6000) of their original (undiscounted) value, while a 12% discount rate (typically used by multilateral international lenders such as the World Bank) yields a paltry NPV of 0.1% (see Table 1) of the original estimate! Private investors and even non-profit institutions may use higher discount rates. How does the mechanics of DCF affect the value of $6 of future savings against $1 dollar spent today on hazard mitigation? Well, for starters, the mechanics of DCF is not designed to accommodate contingent liabilities, so it does not account for it. Spending $1 today is simply viewed as an added expense that has no impact on the project cash flow risk profile. At best, decision makers may consider investing in risk reduction rationally by assessing the likelihood of a given event taking place in the near future. For instance, for a 12% discount rate, the present value of $6K would be higher than $1K for years 1-15 (see Table 1). Hence, a decision maker would not consider investing in risk mitigation unless the hazard is expected to take place in the next 15 years. After that, based on standard DCF, the discounted value of the $6 in future savings is lower than a $1 dollar spent today.
By arbitrarily increasing discount rates to account for additional risk (real or perceived), the widespread use of discounting masks the effect of risk on investment performance, which makes it difficult for stakeholders to attain a good understanding of the impact of risk management measures on financial performance and often leads to compensation misallocation for risk assumed by different stakeholders. To finance long-term projects under these terms, investors thus often demand (and obtain) disproportionately large compensation incompatible with their actual risk exposure, which either increases income inequality among project partners or stifles the flow of capital to much-needed long-term investments that could help improve sustainability and reduce to reduce global risks. The main victims of this unsustainable practice tend to be the project’s host communities, who are often too poorly funded and equipped to handle the risks they have unwittingly accepted at inadequate compensation levels. Future generations are most vulnerable because they have no influence over decisions and generally benefit very little from today’s investment practices yet may inherit substantial environmental and other liabilities.
The catastrophic impact of COVID-19 on all sectors of the world economy has exposed the fragility of our current system to global risks and the perils of short-termism. Looming in the horizon is the potential devastating impact of another global risk that does not respects boundaries: climate change. Minimizing negative impacts of climate change on society will require not only massive investments in resilience, adaptation, and mitigation but also across-the-world cooperation among the scientific as well as the investment community. Institutional investors (e.g., pension funds, retirement funds, university endowments) represent a huge and largely untapped pool of capital that could be used to fund such projects in both developed and developing countries. However, to promote meaningful and sustainable capital flows from this investor class, their fund managers will need to understand how non-market risks could directly affect financial performance. Although there is a recent concerted private sector effort to understand how climate change could affect infrastructure performance and liabilities, , unfortunately the current focus is mostly on developing easy-to-use tools at the macro level (i.e., ranking systems and indices) leaving the root of the problem largely untouched.
3.0 A Sustainable Alternative: Decoupled Net Present Value (DNPV)
Despite the significant progress made in the disciplines of finance and economics, reliance on DCF has largely gone unexamined as one of the weaker and more questionable elements in the financial landscape. This is unfortunate, because although devising sound technical solutions to address sustainability issues is vital, more effort is needed to prevent these ideas from being wasted due to lack of funding. Such effort includes developing and disseminating accurate, consistent and transparent valuation techniques that explicitly incorporate physical (and other) risk sources,. As a first step, there is much to be gained from revisiting old concepts, including many that might have been previously discarded as impractical due to computational power limitations, and coupling them with new ideas from diverse disciplines including engineering, behavioral economics, mathematics, and data analytics. One such example is the decoupled net present value (DNPV) method (see Box 1) proposed as an alternative to NPV for valuation of long-term infrastructure investments. The DNPV approach consistently translates technical assessment of physical and other risks into financial terms by quantifying in monetary terms the potential exposure of an asset to identified hazards including climate change.
The benefits of quantifying individual risks in monetary terms and treating them as costs to the project are numerous: (1) It is more natural to describe risk in monetary terms as it reflects our everyday experience filled with examples of cost of risk (e.g., car insurance premiums, health care premiums, home insurance, life insurance). (2) Contingent liabilities can be taken into account systematically in the cost benefit analysis process. Investors and project sponsors can profit from
Box 1: Decoupled Net Present Value (DNPV)
The DNPV method (www.dnpv.org) is a valuation framework consistent with Prospect Theory and uses certainty equivalent concepts that decouple the time value of money from risk. DNPV introduces the risk-as-a-cost concept to account for the loss-aversion attitude of rational investors. The cost of risk is related to the downside potential of an investment and is included in the cash flows as a project cost as the effective price to protect an investor against individually identified risks. Because identified project risks are quantified in monetary terms and treated as real costs to the project, the need for massaging the discount rate to account for actual and perceived risks is no longer necessary. Future cash flows reduced by the identified costs of risks can simply be discounted using quoted risk-free rates.
4.0 Applying the DNPV Method
technical experts from other disciplines (e.g., engineers, scientists, sociologists, epidemiologists) to assess the magnitude of the identified contingent liabilities. (3) Because risks are quantified, risk managers can adopt appropriate measures to reduce exposure including assigning risks to their “most rightful” owners, and thus project risk profiles can be reassessed. (4) The effect of risk management (i.e., avoid, reduce, mitigate, transfer, or retain identified risks) on return of investment can be assessed in an objective and consistent manner. (5) Because DNPV requires project-specific risk quantification, its adoption would foster better data collection for key risk drivers and exchange of information across industries, which iteratively will improve the method’s accuracy and ability to develop effective risk management measure over time. (6) DNPV removes the guess work associated with the discount rate. Since risk has been accounted for in the cash flows, the discount rate is simply quoted in risk-free rates.
An application example is presented in Table 3 for both the traditional NPV approach and the proposed DNPV to illustrate the concept. The example represents an initial capital expenditure (CAPEX) of $110M that would generate $25M of annual revenues with an annual operating expenditure (OPEX) of $10M (in today’s dollars), resulting in a $15M of net revenues for a period of 40 years. Without losing generality, it is assumed that climate change is the only risk that may affect this investment with an estimated annual probability of occurrence of 4%. For this investment, it is assumed that the investor opportunity cost of capital is 5%. The corresponding NPV for the cash flows is $147.4M (Line E). Let’s assume that the manager has the option to make the facility climate change resilient by investing an additional CAPEX of $10M (increasing CAPEX in Line D to $120M) and avoid a potential $60M loses due to asset damages and production loss. As indicated above, traditional DCF cannot account for the contingent liability. Thus, making the additional investment of $10M would reduce the NPV to $137.4M. Under DNPV, the $60M contingent liability can be taken into account as an annual cost of risk of $2.4M (4%×60M) which would be included in the cash flow as a cost (see table below). Because risk is taken into account in this manner, the resulting cash flow can be discounted using a risk-free rate. The risk-free rate was selected from the information obtained for 30-yr treasuries (quoted at 2.4%). Because cash flows are in real terms (today’s dollars), the real discount (i.e., net of inflation) is approximately 1%. The DNPV for the facility without climate change resilient features is $302.2. If the $10M is invested, the annual $2.4M liability (Line G) can be removed from the cash flows resulting in a DNPV of $370.7. As shown in this simple example, the mechanics of the DNPV method is relatively straight forward and easy to implement.
Table 3: Simplified DNPV Example
Unfortunately, because DCF is deceptively simple, it could remain at the core of most popular valuation methods for years to come. For instance, very recent methodologies put forward to assess carbon emission savings and monetize the social benefits (and costs) across time are based upon DCF techniques. Hence, artful persuasion and well-designed implementation paths will be needed to address typical natural resistance to new ideas and facilitate their acceptance and widespread use by private, public, and non-profit institutions. Moving away from well-established practices takes significant time and effort, particularly when existing methodologies are simpler and expedient, easy to communicate to decision makers, and so deeply rooted as to be included in public policy. In addition, when sectors of the economy who are in charge of making such changes benefit from the status-quo, they cannot be counted on to support adoption of disruptive ideas. However, due in no small part to global risks threat, a significant effort must be directed towards addressing the issue of discounting at least to evaluate public investments. Some of the benefits associated with considering risks as actual costs and adopting methods such as DNPV are listed below.
- DNPV can consistently correlate investments in resilience with reductions in climate change risk and assess the effect of adopting such measures.
- The adoption of DNPV as valuation a framework to perform cost benefit analysis would foster data collection, standardization of risk quantification, and analysis of the effect of physical risks on investment performance.
- Because DNPV requires explicit quantification of physical risks in monetary terms, its adoption can facilitate disclosure transparency of long-term liabilities (e.g., climate change) by publicly traded companies.
- Performing cost benefit analysis of long-term multi-generational projects funded with public monies using government-mandated discount rates would no longer be required.
- Projects partially/fully funded by private capital through public-private-partnerships would be compensated for risks actually taken.
Continued use of standard financial analysis such as DCF that is predicated upon discounting the future tends to portray investments in sustainability typically with long-term payback periods as a philanthropic endeavor performed to enhance corporate social responsibility rather than as a strategic investment. By pivoting to a robust valuation method such as DNPV that can handle ever-changing risks and integrate them in a consistent and transparent manner, long-term projects with far-sighted mitigation and adaptation objectives could finally be evaluated on an equal footing with short-term opportunities. Benefits abound, including enabling project developers and planners to promote desperately needed investments in mitigation and adaptation measures to safeguard essential public and private assets. This could go a long way toward offering future generations the chance of inheriting a livable planet.
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