Thoughts around using a high discount rate

Higher discount rates may be used to reflect the greater risk averseness adopted by a company/project manager. This may also be used as a screening tool, with lower NPV projects rejected. In O&G, and other fields, higher discount rates should be used in conjunction with other tools to evaluate projects.

At the planning level, the use of higher discount rates has its own limitations due to conflicting interests between the project team (e.g. staying in the job) and management.

• Encourages projects with near term and/or higher levels of early production 
• Implication: capex spent on projects with shorter lives at expense of a developing longer life assets; capex is accelerated
• Capex is low-balled to get projects/wells approved
• Implication: actual costs are inevitably higher leading to under-performance of project; capital not deployed efficiently
• Riskier exploration may be undertaken
• Implication: more optimistic view taken on reserves and costs to push projects forward

The above actually leads to projects that are inherently more risky being undertaken and increases the exposure of the business to risk, countering the original intentional of using a higher discount rate!

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