Do consumers discount the future correctly?: A market-based valuation of residential fuel switching

DSM and energy-efficiency options are generally evaluated using engineering oriented discounted cash flow procedures which value all cost and benefit streams using a single arbitrary discount rate — usually the firm's weighted average cost of capital (WACC). The WACC based approach ignores financial risk and hence leads to unreliable results. In a recent paper in this journal Hassett and Metcalf depart from this tradition; they reflect financial risk by simulating the total variability of returns from energy saving investments. Their findings indicate that DSM projects are potentially risky, suggesting that the net benefits must be discounted at significantly higher rates, thus lowering their present values. This paper presents a market based evaluation of a particular DSM option — residential fuel switching — using the capital asset pricing model (CAPM). Under the CAPM approach, a risk adjusted, market based discount rate is estimated for each cost stream — fuel, maintenance and avoided outlays for electricity. The market based results, which reflect the systematic risk of each cost stream, suggest that fuel switching is probably not cost-effective because it is considerably more risky than indicated by a WACC based analysis. This supports Hassett and Metcalf's conclusion that consumers who reject DSM projects are not necessarily acting irrationally.