The #costofcapital in public sector planning

In this month’s edition of Prospect, John Kay examines the methods used by the Airport Commission, which compared the merits of an extra runway at London Heathrow or at Gatwick (pictured).

Gatwick 612 2

[W]hat figure should be used for the cost of capital? There are several possibilities. First, the risk free rate at which the British government can borrow. The longest dated index-linked gilt, maturing in 2068, currently yields minus 1 per cent. Second, the “green book” rate prescribed by the UK Treasury used in the Commission’s cost-benefit analysis, and fixed arbitrarily in 2003 at 3.5 per cent in real terms. Third, the anticipated cost of the Private Finance Initiative-type deal which it is anticipated will be employed to fund airport developments – around 5 per cent – 6 per cent in nominal terms. The final possibility is to use the weighted average cost of airport capital of between 5 per cent and 6 per cent real terms, as set by the CAA, British’s airport regulator… [A]rguably it is the first… which is the most relevant. Which rate is used makes all the difference. At minus 1 per cent over a life of 60 years, the annual cost of the proposed capital expenditure at Heathrow is about £250m. At 3.5 per cent, the figure is £800m. At and 5.5 per cent the annual cost becomes £1.35bn.

Published by

Paul Hodson

Head of Unit "EnergyEfficiency" at European Commission, Directorate-General for Energy

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