Energy Transition in Oil-Dependent Economies: Public Discount Rates for Investment Project Evaluation

Fatih Karanfil and Axel Pierru

Discussion Papers from King Abdullah Petroleum Studies and Research Center

Abstract: The selection of welfare-enhancing projects necessitates the determination of the present value of cash flows from a public policy perspective. For an oil-exporting economy, the domestic energy transition often implies displacing oil from domestic consumption. Economic dependence on oil affects the public discount rate for oil-related cash flows in two opposite ways. On the one hand, it renders the economy more volatile, lowering the risk-free discount rate; on the other hand, it increases the correlation between consumption and the oil price, resulting in a higher risk premium. To study these opposite effects, we first derive the public discount rate for an oil-related investment project. Our framework considers economic uncertainty and an oil price-related risk premium, and it makes it possible to value oil at its opportunity cost. We illustrate our methodology using data from a panel of 26 oil-exporting countries. The results indicate that a risk-free discount rate of 3.1% is appropriate for our panel. However, to discount oil-related cash flows, a risk premium of 1.4% needs to be added to the risk-free rate, yielding a risk-adjusted real discount rate of 4.5%. We find significant disparities between country-specific public discount rates. Additionally, for each country, we assess the present value of reducing domestic oil consumption by a barrel per day from 2023 to 2040, decomposing the different effects. Oil-exporting countries can use our estimates to make investment or policy decisions.

Keywords: Applied general model; Bottom up model; Discount rate; Discounting (search for similar items in EconPapers)
Pages: 42
Date: 2024-06-05
New Economics Papers: this item is included in nep-ene and nep-ppm
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Persistent link: https://EconPapers.repec.org/RePEc:prc:dpaper:ks--2024-dp09

DOI: 10.30573/KS--2024-DP09

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