For major project feasibility and decision making, if cost and benefit items have been identified and valued, the net difference of costs and benefits need to be considered in relation to time.
The reason that time is factored into a particular project is to account for the change in the value of money over the project period. The value of money changes over time due to fundamental principles of how people will prefer to satisfy want now rather than later. Conversely, people will also typically prefer costs later rather than now.
As an example satisfaction of wants such as buying a house will be preferred now (from a consumer point of view), although the costs of paying for the house would be preferred sometime into the future or even deferred to the point of non-payment (if the seller allows it). This difference in satisfaction now and incurred cost at a later date, meaning that goods and services will typically have a higher net benefit and cost in the future, and thus this change in future increased good or service’s value needs to be discounted back to today’s price of money.
Or put differently, because individuals attach less weight to a benefit or cost of a project in the future than they do to a benefit or cost now (because the transaction is important to the buyer and seller at today’s monetary value), the monetary value will have to be adjusted (or discounted) to more accurately depict the true net cost or benefit at time periods ranging from the start of the project to the end of the project.
To apply an example, the future benefit of infrastructure in year 1 may be valued at $100M and in 20 years may be valued at $10M, but this value in year 20 the net benefit of £10M is using the cost of money 20 years ago so needs to be adjusted. The discount rate operates like the opposite to interest if money was saved rather than invested, for instance, if money (M) is put into the bank (rather than invested in infrastructure) at an interest at 10% over 20 years the value of money in 20 years would be worth Mx20x10%. To counteract an opportunity cost foregone in savings (% interest received from the bank) when investing (in infrastructure), the discount rate of money needs to be applied for each period of time.
This method of discounting can consider the ‘real’ net cost or benefit of goods and services over time – but it can also be used to consider the environmental impact of project over many years that stretch over several generations (e.g. 100 years). For instance the net benefit of a pollution control initiative can be valued into the future whilst calculating how the changing value of money will affect the net benefit at certain time periods.
Note that the discounting technique is simply to generate estimated valuations into future periods, and does not necessarily reduce environmental costs in the future. For instance, the changing of discount rates can be used to alter the amount of net benefit or cost that will be incurred towards the start of the project (say in year 5) or at the end of the project (say in year 20). If there was a reduction in the discount rate from 10% to 5% this would mean that the net benefit or cost is discounted more in the earlier years and would have less consideration for future net benefits or cost. As the inverse, an increase in the discount rate from 5% to 10% would mean that net benefit or cost would be discounted less in earlier years and have more consideration for future net benefits or cost.
A more in-depth example is applied shortly but what this means is this, if higher discount rates (e.g. 10% rather than 5%) are applied to a project that has high environmental/social impact costs in the future, the ‘real’ monetary costs will of these high future costs have been considered and dampened in the model – to account for how money will be worth less in the future.
To round of this initial discussion in lay terms, discounting occurs as people would prefer to have a dollar in there hand today rather than in the future because the dollar will be worth less in the future. This in turn means that if the dollar is worth less in the future, any project in the future that has benefits or costs, needs to be adjusted account for such devaluation of money over time.