What is the Green Book Rate?

In a speech on growth on 7th September, our newly appointed Chancellor John Healey announced a change to the ‘green book’ rate from 3.5% to 3.0%, in order to encourage more projects that have longer term benefits. So what is this rate and how might its reduction help?

The ‘Green Book’ is UK Government guidance on investment appraisal. It gives guidance on how to assess the costs and benefits of something when it involves the spending of public money. Its use is mandatory for government departments and arm’s length public bodies. UK local authorities commonly also rely on it.

One of the many things covered by the book is the ‘discount rate’, which is more properly called the ‘Social Time Preference Rate (STPR)’. it represents the idea that £100 of public spending now is more useful than £100 spent a year from now, and much better than £100 in 10 years’ time. In other words, It represents the ‘time value of money’.

Putting a numerical value on the time value of money is clearly subjective and fraught with difficulty. If anyone wants a nerdy foray into how the government calculates it there is further green book guidance on how the rate is derived here. As a rough guide here are the elements that are considered:

- Human nature: everyone would rather have something now than later.

- Risk: the longer you have to wait for something, the more risk that it may not actually materialise. The green book talks about this as ‘catastrophic risk’: meaning unpredictable risks that wouldn’t have been thought about as part of the main appraisal.

- The ‘wealth effect’. The essential idea is that GDP per person is expected to increase and people will get wealthier with time. £100 is less significant to the wellbeing of someone who is rich than someone who is poor. Thus if we get richer, £100 in the future will be less worth to us.

The current green book rate of 3.5% is calculated from a ‘human nature’ element of 0.5%, a ‘risk’ element of 1.0% and GDP growth per person assumption of 2.0%. This 3.5% rate applies to periods of 30 years or less, for over 30 years the rate is 3.0% and for over 75 years it is 2.5%.

Importantly the green book discount rate does not include the effect of inflation. It should therefore be applied to the real value, not the nominal value, of future costs or benefits. If inflation is 2% then £100 in a year’s time will actually be worth £98 in real terms. You need to apply any discount rate to the £98 not the £100 to get the proper picture. This in reality means future numbers should be discounted twice: once for inflation and a second time for the time value of money.

The Chancellor is changing the rate because the higher the discount rate the less value future returns on something will have. If the rate is 3.5%, £100 now is worth £71 in 10 years’ time. If the rate is 5.0%, £100 now will be worth £61 in 10 years’ time. Thus if a project has costs in the short term, but benefits in the longer term, it will look like a worse project if the discount rate is higher, because those benefits are happening further away in the future and will look smaller with a higher discount rate. The British government (although they wouldn’t be the only ones) is frequently accused of not doing things it should to benefit in the long term, because of short term costs. If the green book rate is reduced this should make some of these projects, that didn’t look worth it before, now look like they will offer value for money. Mr Healey therefore hopes that more projects of this nature will go ahead, rather than just being left on the drawing board.

What is important to understand is that lowering the discount rate doesn’t change how much projects will actually cost or how much income, savings or other non-monetary values you will gain from them. Unfortunately many of these things are much harder to control. In particular at the current time, debt interest rates continue to soar, making any project that will require borrowing much more expensive. Rises in oil and energy costs associated with the blocking of the Straits of Hormuz will also make everything more expensive. So whilst the Chancellor’s decision might be a step in the right direction, there are still lots of obstacles to face.

Arlingclose has extensive experience of assisting clients in financial cost benefit analysis. If you require any assistance in this area please contact the Arlingclose team at info@arlingclose.com or on 08448 808 200.