5  Methods used in the public sector

After broadly examining the options above, it is useful to examine the methods currently used in government. In practice the use of the capital asset pricing model (CAPM) dominates in determining a cost of capital, and other models are not considered superior. The use of CAPM reflects an opportunity cost of capital approach.

The CAPM formula is used to calculate the expected return on equity for government departments. This is then used in a weighted average cost of capital (WACC) formula to take account of the assumed debt equity structure in government departments. The departmental capital charge rate, 9.0% for 2001/02, reduced to 8.5% for 2002/03, represents the average business risk across all departments. It is a real rate. The capital charge system gives departments an incentive to use the taxpayers’ investment in the department in the best possible way. It is set to be comparable to investments of a similar risk in the private sector. As the government is looking at it from a whole of government perspective this is a social opportunity cost, although it is making some assumption about the next best option having the same characteristics as public investment. The government wants to ensure the best use of existing resources within the public sector.

The departmental capital charge rate is often used as a de facto discount rate by departments for calculating the net present value of an investment or alternative policy options. This is likely to be because it is the opportunity cost of their existing capital. If they seek capital contributions these have the same capital charge rate as their existing capital.

The government also uses the CAPM and WACC formulas to calculate the expected rate of return for State Owned Enterprises.

In addition, the New Zealand Treasury uses a 10% real rate whenever there is no other agreed sector discount rate for costing policy proposals.[4] Wilkinson (1982) outlines the long history of the 10% discount rate. Cabinet set this rate in 1971 and the Minister of Finance reaffirmed it in the 1982 Budget. The rate was based on the opportunity cost of capital based on the expected return of a low risk private sector investment at the time. Current Cabinet Office circulars do not refer to the 10% real discount rate as a standard rate. The Cabinet Office Circular (CO (00) 12 Annex One) requires that business cases should identify and detail “the discount rate used, and its derivation” amongst other things.

It is useful to contrast the New Zealand experience with overseas experience. For instance, in the context of health research Wright (1998 p.12) comments that:

“The current preferred proxy for the society’s rate of pure time preference being the real interest-rate on a risk-free long-term investment. Using this approach, the U.S. Panel on Cost Effectiveness in Health and Medicine recommended using a rate of 3%.”

Wright (1998 p. 12) also comments, “For some years, the convention in the health economics literature has been to use a 5% discount rate for cost-effectiveness and cost-utility analyses”.^[5] Her paper details that the U.S. Panel then recommend the use of both 3% and 5% for base-case analysis and critical sensitivity analyses. This recommendation would reflect the US situation and not the New Zealand situation.

“The Green Book”[6] on appraisal and evaluation in central government issued by HM Treasury (1997 p. 24) details that “ for most applications in central government the real discount rate is 6 per cent. … Exceptions include industrial assistance proposals and projects under the overseas aid programme.” This rate has been in effect since 1989. Parsonage and Neuburger (1992) state that this standard rate was widely used and had almost invariably been applied to costs and benefits.

Wright (1998) suggests that researchers in New Zealand may want to use overseas rates to check their results,for example in the health sector where considerable research is undertaken overseas. This does not mean that for decision-making purposes that the same discount rate should be used in government decision making if it does not reflect the discount rate applicable to that situation in New Zealand. For example it is likely that the discount rate would be different in New Zealand. The New Zealand government bond rate would be used in New Zealand as the risk free rate and this is higher than the US bond rate.