f97.beERIK SCHMIDT’S WORKSHOP
← All terms

Glossary · Energy industry & energy transition

Discount rate

Discount Rate financing Investments power system cost assessment WACC

Definition and basic idea

The discount rate is the interest rate used to convert future payments into a present value (discounting). In an investment appraisal, it answers the question of how much a payment that only falls due in a later year is worth today. The discount rate is not a technical property of a plant. It is a valuation rule for time, risk and capital commitment.

The associated calculation quantity is the present value. A payment in year t is divided by the discount factor (1 + r) to the power of t, where r is the discount rate. Because time appears in the exponent, even small differences in the interest rate change the present value significantly, especially over long periods. An example: 1,000 euros received in ten years are worth about 614 euros today at 5 percent. At 2 percent it would be about 820 euros, and at 8 percent only about 463 euros. The higher the discount rate, the less later costs, revenues or savings count in today's calculation.

Why the discount rate matters so much in the electricity system

Many central assets in the electricity system are capital-intensive and long-lived. Power grids, wind farms, photovoltaic systems, hydropower plants, storage, electrolysers, building retrofits or heat pumps incur a large share of their costs at the beginning. Their revenues or savings, by contrast, are spread over many years. Fossil-fuel power plants also require investment. For them, however, ongoing fuel costs, CO₂ costs and variable operating costs play a larger role. A high discount rate therefore weighs mainly on technologies and infrastructures whose costs arise early and whose benefits lie far in the future.

The discount rate appears particularly often in levelised cost of electricity. This indicator divides the sum of the discounted costs of a plant by the sum of its likewise discounted electricity generation over its lifetime. For wind and solar plants, the calculated levelised cost of electricity reacts strongly to the discount rate, because the investment comes first and there are practically no fuel costs. For a gas-fired power plant, a considerable share of the costs arises later through fuel and CO₂ allowances. There the discount rate has a weaker effect. A comparison of levelised costs of electricity without stating the discount rate is therefore technically incomplete. For storage, the same logic applies to storage costs per discharged kilowatt-hour.

The discount rate also shapes how system costs are perceived. If future fuel imports, CO₂ costs, grid bottlenecks, maintenance or replacement investments are discounted heavily, solutions that are cheaper in the short term look more favourable. If later savings and avoided damage are weighted more heavily, long-lived investments fare better. The discount rate thus does not decide the result alone. But it determines how strongly the future counts in today's calculation.

Market interest rate, cost of capital and social discount rate

The discount rate is often equated with a market interest rate. That is imprecise. A market interest rate describes the terms on which capital can be borrowed or invested. A discount rate in a project calculation may be derived from it. Depending on its purpose, however, it contains further assumptions, such as risk premiums, returns on equity, debt costs, inflation expectations, tax effects or a social time preference.

Corporate calculations often use the weighted average cost of capital (WACC). It weights equity and debt costs according to their shares in the financing. German grid regulation provides an example: for gas networks, the Bundesnetzagentur (Federal Network Agency) assumes, in its draft determination of August 2026, a flat 40 percent equity and 60 percent debt. With a pre-tax cost of equity of 5.76 percent and a cost of debt of 2.43 percent, this results in a WACC rate of 3.76 percent.

A macroeconomic or governmental discount rate follows a different logic. It is not primarily meant to reflect an investor's expected return, but to value future social costs and benefits. Such social discount rates are usually well below private costs of capital. They are set differently depending on the country and guidance document and are occasionally reviewed. Especially for climate damages over decades, even a difference of one percentage point changes the result considerably.

Nominal or real

A nominal discount rate includes inflation expectations; a real discount rate is adjusted for inflation. Approximately: (1 + nominal) = (1 + real) × (1 + inflation). At 5 percent nominal and 2 percent inflation, the real rate is therefore about 2.9 percent, not exactly 3 percent. If future payments are calculated in today's prices, a real discount rate is appropriate. If they are expressed in future nominal prices, a nominal rate fits. Mixing the price basis and the discount rate produces distorted results, for example when comparing the costs of power plants, grid measures or efficiency measures. It must also be clear whether a rate is stated before or after tax.

Distinction from related quantities

  • Loan interest rate: the cost of a specific debt financing.

  • Required return: the return an investor expects on its equity.

  • Capitalisation rate: used in a similar way, above all in the valuation of companies and assets.

  • Inflation rate: describes price changes, not the present value of future payments.

  • Internal rate of return: is the result of a calculation, not an input. It indicates the discount rate at which the net present value of a project becomes zero.

  • Discount rate of the Deutsche Bundesbank: a former key monetary policy rate, not to be confused with the discount rate in investment appraisal. It no longer exists since the introduction of the euro. In laws and contracts, the base interest rate (Basiszinssatz) under § 247 of the German Civil Code (BGB) takes its place.

No hidden truth value

A high discount rate does not prove that a technology is objectively expensive. It only shows that it appears expensive under certain financing conditions or risk assessments. A low discount rate likewise does not prove that a project is automatically worthwhile. It merely makes later benefits and costs more visible. Whether an investment is viable still depends on technical properties, location, capacity utilisation, market rules, grid connection, permitting risks and operational management. Serious analyses therefore state the rate used and test in sensitivity calculations how the result changes at other values.

A common mistake is to treat the discount rate as a purely mathematical assumption. In practice, it reflects institutional conditions. A wind farm with a long-term offtake agreement, reliable regulation and low permitting risk can be financed more cheaply than a project with uncertain revenues, unclear grid connection conditions or high political risk. The technology has not become more expensive as a result; what has changed is the risk of the cash flows. Support instruments, auction design, government guarantees, regulation and market access therefore affect the investment decision through financing costs.

Regulated electricity grids in Germany

For electricity grids, the return on capital is shaped particularly strongly by institutions. Grid operators finance their investments through grid charges. The regulatory authority determines which return on the capital employed is recognised in the process. Strictly speaking, this regulated interest rate is not a discount rate of a project calculation. But it determines the cost of capital with which grid investments are calculated and refinanced. For the fourth regulatory period of the electricity grids (2024 to 2028), the Bundesnetzagentur set the cost of equity at 5.07 percent for new assets and 3.51 percent for existing assets, in each case before tax.

For new investments settled via the capital cost surcharge (Kapitalkostenaufschlag), a separate rule has applied since a determination of January 2024. The cost of equity there results from an annually variable base rate (the yield on outstanding bonds, Umlaufsrendite) plus a fixed risk premium of 3 percent. This was intended to let the rise in interest rates since 2022 feed through to remuneration more quickly. From the fifth regulatory period, the Bundesnetzagentur intends to switch to a flat WACC approach. A draft was available for gas networks in August 2026. The rates for transmission system operators and electricity distribution system operators are to be set in separate proceedings in 2027. Concrete values for electricity grids from 2029 are therefore not yet fixed.

Behind this lies a trade-off. If the return is too low, it can make investment harder when capital finds better risk-adjusted returns elsewhere. If it is too high, grid costs for consumers rise. It is therefore not only a matter of which line is technically needed. Equally important is which capital remuneration reliably finances a regulated infrastructure without generating unnecessary costs.

Flexibility, storage and electrification

The discount rate has particular significance for the valuation of flexibility, storage and controllable loads. Many flexible assets do not earn their revenues evenly, but in a few hours with large price differences or grid needs. If these revenues are uncertain and lie far in the future, the required return rises. A battery storage system may therefore be technically suitable for balancing short-term fluctuations. Whether it gets financed depends on whether markets and regulation reliably remunerate the expected services.

The discount rate also changes the valuation in electrification. A heat pump, an electric vehicle or an industrial switch to electricity often requires higher initial investment but can later reduce energy, maintenance or CO₂ costs. With a high discount rate, these savings count for less. Investments that would be economically advantageous over the technical lifetime may then not be made. Because of limited access to capital, households and small businesses often calculate with significantly higher implicit discount rates than large investors. The cause then does not necessarily lie in the efficiency of the technology, but in the interplay of access to capital, risk, electricity price structure and expected useful life.

Private and societal perspective

Political debates about the discount rate arise above all where private and societal perspectives diverge. A private investor assesses uncertain revenues, financing costs and project risks. A societal assessment additionally takes into account security of supply, climate costs, import dependencies, grid stability and long-term infrastructure effects. These factors cannot be arbitrarily squeezed into a single interest rate. Anyone who wants to understand a calculation should therefore ask: Which payments are included? Over what period is the calculation made? Which risks are added as premiums? Which costs are left out?

The discount rate makes visible how strongly the present and the future are weighted in a cost assessment. But it does not on its own answer which investment is technically necessary, socially fair or expedient for the energy economy. Its value lies in making long-term payment streams comparable and in revealing which financing conditions, risks and valuation standards enter a calculation.

Sources

Related glossary entries

Edited by eCMS on 11.11.2026 19:21

© 2026 Erik Schmidt. All rights reserved. Quotations with a link to the source are welcome.