Here’s the second part of my discussion of the economics of electrification. You can find part one here.
In order to assess whether electrification of a given line should go ahead, the costs need to be weighed against the benefits through a formal cost-benefit analysis. On top of this, we need to account for the cost of capital and opportunity cost (or what else we could spend the money on). A broadly accepted way of doing this is by calculating the Net present Value (NPV) – the Wikipedia article explains this far better than I can, and is worth reading. Also worth reading is the article on the time value of money – don’t get too worried about it though.
Here’s what the NPV equation looks like, taken from Wikipedia:
If you find the maths intimidating, don’t worry about it – I’m generally terrible at maths so I just use excel to work everything out for me. There’s a link later in this post which allows you to plug in your own numbers and see how changes impact on the viability of a project.
The discount rate and opportunity cost
The discount rate puts money in the future into present value terms. Economists tend to believe that a dollar is worth more to you now than it will be next week – the discount rate measures how much less it will be worth next week. The higher the discount rate, the greater the value placed on the present. In practice though, the discount rate used in these calculations is the cost of capital. The discount rate is also really handy for measuring opportunity cost, so if you can earn 8% by putting that money in the bank, or another project (like using the money to buy more trains) brings in 8% – these figures can be used very effectively as the discount rate and deliver some interesting insights.
Setting the right discount rate is really important – set it too high and worthwhile projects look non-viable; set it too low and non-viable projects look worthwhile. I think a discount rate of somewhere around 7-8% is reasonable for these sort of projects. This article explains very well why setting an appropriate discount rate is necessary.
Most intriguingly, it has been suggested that in reality, politicians face very high effective discount rates – around the 20% mark. With a short electoral cycle, politicians often view the present as much more important than the future. A project with benefits in 20 years (well beyond the current political cycle) is less likely to occur than a pork-barrel which yields political benefits almost immediately. This theory is, in my view, a pretty good explanation of why politicians in Australia are so unlikely to properly support rail.
So now I’m going to set up a very basic NPV calculation in excel, looking at the potential electrification of the Geelong line. The main assumptions I’m making are below. All of these assumptions have problems, but if anything they favour electrification (with perhaps the exception of the 50 year life of the project).
– The capital works for the project would be in the order of $276 million. This is based on the very optimistic assumption of the project costing half of what Craigieburn cost per km. See part one for details.
– No new expenditure for rollingstock would be required. V/Line are going to have to buy lots more anyway and it makes little difference whether they buy more diesel trains or new electrics and cascade the Vlocitys off the Geelong line.
– Service levels would be held constant
– The life of the project would be 50 years
– The discount rate is 8%
Quantifying costs is not so hard – quantifying benefits is difficult. Now to be clear, I don’t believe that there are any economic benefits to electrifying Geelong while service levels are so low. This diagram from part one explains why. But I’m going to make up some absolute best case benefits for the sake of the exercise. Let’s pretend that that electrification will reduce net maintenance levels such that it cuts 5% out of V/Line’s $342.3 million annual expenditure. That’s $17.1 million. Furthermore, let’s pretend that the ‘spark effect’ exists, and that each of the Geelong line’s 2.57 million annual passengers gets an extra $2 utility per trip. That’s $5.1 million per year.
These are the results when the numbers are put into excel (thanks to this website for showing me how to do it properly). Electrification still doesn’t stack up for Geelong even when the costs are underestimated and the benefits overestimated – the NPV is negative to the tune of $4.4 million!
So that’s that – I don’t think the numbers support Geelong electrification unless there are going to be a lot more services running. I’d highly recommend playing around with the NPV in excel by changing around the discount rate, initial investment, benefits and life of the project. Just for fun, behave like a politician and crank up the discount rate to 20%. You’ll understand why we don’t have more infrastructure with long term benefits!