The Issue: Favoring the Present and Neglecting the Future
There is no limit to human ingenuity - it has always been society’s greatest means to solve global problems. We only have to look around to see the advancements in science and technology that are improving our lives. That is why we are optimistic that we can innovate through society’s most pressing issues (e.g., climate change, water scarcity, energy independence). But, despite the tools and the will, our greatest challenge may be our ability to finance those ideas in time. Why? Because, despite our technological achievements, decisions that affect future generations are still based on arcane financial methods, a.k.a. net present value (NPV) and its close relative the internal rate of return (IRR), whose main tenet is the commingling of the time value of money and risk in a single number known as the discount rate. The use of NPV methods has for many years resulted in severe economic distortions and perverse incentives as the value of the present is overemphasized whereas the value of the future is under-emphasized. This has led to a widespread time-bias effect favoring short-term investment decisions. Unfortunately, these anachronistic models (devised for simpler investment opportunities in the fifties, an era when simple algorithms were a necessity to minimize expensive computational power) are ubiquitous. Although computational cost has decreased over 10 billion times in the meantime, which should make it hard to justify using grossly simplified NPV models, moving away from well-established practices takes significant time and effort, particularly when existing methodologies are expedient and deeply rooted in public policy. However, the status quo will continue to lead us to inaccurate investment valuations, postponing much needed investments in many different areas, and unduly penalizing future generations and communities that can least afford it.
Despite its well-known limitations, the simplicity of the net present value (NPV) technique has contributed to its widespread ubiquity for assessment of investment opportunities and capital allocation. Although time and risk are indeed independent variables, in the NPV method, all risks associated with a project are represented by a single parameter (the risk premium) that is added to the risk-free interest rate to obtain the discount rate: that is, the time value of money is adjusted to account for risk. However, because NPV calculations are highly sensitive to the selected discount rate, the current practice of selecting a constant discount rate based on heuristic arguments and rules of thumb has invariably lead to a significant time bias effect that promotes transference of risk to unsuspecting stakeholders, often from less advantaged communities or future generations. Under the standard NPV valuation method, selected discount rates simply represent the investor’s desired return not the actual project risk. This widespread practice makes it difficult to take direct advantage of experts’ experience in a particular field (e.g., energy generation, mine operation, oil and gas exploration, civil infrastructure design, or pharmaceutical research and development) or to gather and use data in a systematic manner.