Test Discount Rate (Hansard, 5 April 1978)

§ Mr. Joel Barnett

The White Paper on nationalised industries, published today, indicates that financial targets for these industries should take account of the opportunity cost of capital by means of a required rate of return—RRR—which they would be expected to achieve on the totality of their new investment, Cmnd. 7131, paragraphs 58–65. This required rate of return has been fixed at 5 per cent. in real terms—before tax. 'The responsibility of devising methods of investment appraisal which would achieve this will rest with industries in consultation with their sponsor departments. The Government will therefore no longer specify a general test discount rate for project appraisal by nationalised industries.

The opportunity cost of capital, representing the rate which an investment would have to earn in order to justify in economic terms the commitment of national resources which could be used in other ways, is equally relevant to investment decisions in other parts of the public sector, and the Government have been considering how best to bring this consideration to bear on decision-making in this area.

Some of the other public sector bodies concerned—the water authorities, the Royal Mint, the Royal Ordnance Factories, and so on—are engaged in trading services similar to those of the nationalised industries. The Government will consult these bodies about the extent to which similar financial arrangements, 148W adapted to their particular circumstances, would be appropriate.

Apart from the nationalised industries, most of the public sector cannot be brought within the framework of financial objectives and the RRR system because the services are not provided on a trading basis. To promote the efficient use of national resources, however, it is necessary to retain project appraisal in the non-trading public services. In selecting the appraisal rate consistent with the general objective in Cmnd. 7131, account has to be taken of the special circumstances; for example, the absence of market forces and the greater risk of appraisal optimism for projects whose returns are primarily non-financial. The appraisal rate will generally, therefore, need to be set somewhat higher than the rate of 5 per cent. which reflects the opportunity cost of capital. Taking these considerations into account, a rate of 7 per cent. is considered to be generally appropriate for appraisal in the non-trading public services. However, in certain cases a different rate may be used, depending on the circumstances of the case; the Departments concerned will consider, in consultation with the Treasury, the rate to be applied in the particular circumstances. Where investment decisions are solely concerned with the choice of the best technique for producing a given output, or with issues concerning the phasing of capital expenditure, the appropriate rate would be the rate representing the opportunity cost of capital.