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The Shadow Price of Capital: Accounting for Capital Displacement in Benefit–Cost Analysis

Author

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  • Newell, Richard G.

    (Resources for the Future)

  • Prest, Brian C.

    (Resources for the Future)

  • Pizer, William

    (Resources for the Future)

Abstract

Government analysts have long used discount rates based on investment rates of return to approximate the effect of capital displacement. However, we show how this approach is deeply flawed and produces highly biased results, particularly in the context of decisions involving long-lived impacts such as climate change. We demonstrate how analysts can use the superior shadow price of capital (SPC) approach in a straightforward manner to account for concerns about capital displacement in federal regulatory analysis. We derive a formula for the SPC as a function of four key parameters and propose a central SPC value of 1.1, with a reasonable range of 1.1 to 1.2. We then illustrate how the SPC approach could be easily implemented in practice using the example of the 2015 Clean Power Plan Regulatory Impact Analysis, showing that estimated net benefits are far less sensitive to capital displacement concerns under the analytically correct SPC approach as compared to the incorrect approach of using a 7 percent investment rate or return. Our work is particularly important given the ongoing efforts to revise federal guidance for benefit-cost analysis and discounting.

Suggested Citation

  • Newell, Richard G. & Prest, Brian C. & Pizer, William, 2023. "The Shadow Price of Capital: Accounting for Capital Displacement in Benefit–Cost Analysis," RFF Working Paper Series 23-07, Resources for the Future.
    • Handle: RePEc:rff:dpaper:dp-23-07
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    References listed on IDEAS

    as
    1. Richard G. Newell & William A. Pizer & Brian C. Prest, 2022. "A Discounting Rule for the Social Cost of Carbon," Journal of the Association of Environmental and Resource Economists, University of Chicago Press, vol. 9(5), pages 1017-1046.
    2. Tamma Carleton & Michael Greenstone, 2022. "A Guide to Updating the US Government’s Social Cost of Carbon," Review of Environmental Economics and Policy, University of Chicago Press, vol. 16(2), pages 196-218.
    3. Mark A. Moore & Anthony E. Boardman & Aidan R. Vining & David L. Weimer & David H. Greenberg, 2004. "“Just give me a number!” Practical values for the social discount rate," Journal of Policy Analysis and Management, John Wiley & Sons, Ltd., vol. 23(4), pages 789-812.
    4. Stephen A. Marglin, 1963. "The Opportunity Costs of Public Investment," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 77(2), pages 274-289.
    5. Li, Qingran & Pizer, William A., 2021. "Use of the consumption discount rate for public policy over the distant future," Journal of Environmental Economics and Management, Elsevier, vol. 107(C).
    Full references (including those not matched with items on IDEAS)

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    More about this item

    JEL classification:

    • D61 - Microeconomics - - Welfare Economics - - - Allocative Efficiency; Cost-Benefit Analysis
    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • E22 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Investment; Capital; Intangible Capital; Capacity
    • H43 - Public Economics - - Publicly Provided Goods - - - Project Evaluation; Social Discount Rate

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