INSIDE THE DOT
South Dakota Department of Transportation
Selection of interest and inflation rates for infrastructure investment analyses
Xiao Qin, SDSU
Estimates of interest and inflation rates allow transportation planners to compare the costs of different investment alternatives. The interest rate reflects the time value or the opportunity cost of money. It is equal to the economic return that could be earned by investing in an interest bearing account. The inflation rate reflects how much goods and services will cost in the future as compared to today. The difference between the interest rate and inflation rate, called the real discount rate, determines whether projects with low initial cost or high initial cost are more favorable. Using inappropriate values of interest rate and inflation rate could unfairly favor certain industries, such as concrete over asphalt or vice versa, detracting from the department’s credibility in its investment decisions. SDDOT uses interest and inflation rates for a variety of planning activities, including the development of its five-year Statewide Transportation Improvement Program (STIP), life cycle cost analysis (LCCA) used to evaluate pavement and bridge rehabilitation and replacement alternatives, and valuing roads transferred from the state highway system to counties. Different rates and analysis periods are used for various applications and assets because different types of infrastructure may have different components with unique cost escalation rates and service lives. For instance, the National Consumer Price Index (CPI) is currently used to estimate inflation in the STIP, while the South Dakota Construction Composite Index (CCI) is used in pavement LCCA. Bridges have a longer service life than pavements, so the analysis period used for bridge projects is longer than for pavement projects. SDDOT is uncertain whether the appropriate interest and inflation rates are being used for the various planning activities. For example, the South Dakota Construction Composite Index used in LCCA has been extremely volatile, increasing by 6.31% between CY2010 to CY2011. In addition, there is a great deal of variation among individual material inflation rates used to create the CCI. Because the CCI is based primarily on paving materials, its applicability to other construction types is questionable. The Office of Project Development has used both a ten-year average and a five-year average of the percent change in the South Dakota CCI updated annually, further showing the volatility of the CCI. SDDOT generally assumes a zero interest rate, in effect equating the real discount rate to the inflation rate, but the validity of this approach may need to be verified. There is a need to characterize SDDOT’s uses for interest and inflation rates and to determine whether the appropriate rates are being used in the various settings. Procedures for establishing and maintaining credible and equitable rates need to be identified.
1 1) Identify and describe the various uses of interest and inflation rates in SDDOT and determine how critical discounting is for each application.
2 2) Examine and evaluate methods for establishing sound interest and inflation rates used for infrastructure investments in South Dakota.
3 3) Examine the South Dakota Construction Cost Index and determine whether there is a need for asset-specific indices.
4 4) Propose a methodology for establishing and maintaining sound and equitable interest and inflation rates for different applications within the SDDOT.
1 Meet with the project’s technical panel to review the project scope and work plan.
2 Review and summarize literature directed toward current federal and state methodologies for interest, inflation, and discount rate determination and economic analysis.
3 Interview members of SDDOT selected by the technical panel to determine how economic analysis is performed in each office and planning stage and how interest and inflation rates are determined.
4 Perform a sensitivity analysis to evaluate and compare different methods of calculating interest and inflation rates.
5 Submit a technical memorandum and meet with the technical panel to discuss the literature review, interviews, and sensitivity analysis.
6 Propose a method(s) for deriving sound and equitable interest and inflation rates based upon the results of the literature review, interviews, and sensitivity analysis and the ease of updating, user-friendliness, and availability of data sources.
7 Compare actual historical inflation and interest rates to rates currently being used by the SDDOT and to rates predicted by the new method(s).
8 Using the proposed method(s), recommend interest and inflation rates to be used by the SDDOT.
9 Meet with the project technical panel to present project findings.
10 Provide training to representatives of SDDOT offices and industries affected by the research.
11 Prepare a final report summarizing the research methodology, findings, conclusions, and recommendations.
12 Make an executive presentation to the SDDOT Research Review Board at the conclusion of the project.
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