Let's Talk About Net Present Value and Solar Panels

That $10 a year from now is worth less than $10 today just makes sense, right? You might die in the interim, or you might have some use you could put the money to over the next year (an investment, say). Plus, there's the threat of inflation: You might not be able to buy as much with $10 years from now as you can now. Figuring out exactly how much less that $10 is worth is a bit less straightforward, of course. It's all about the choice of discount rate, and while sometimes that's obvious, in many real-world applications, it is not. "Discount-rate variation," John Cochrane said in his presidential address to the American Finance Association in 2011, "is the central organizing question of current asset-pricing research."

So present-value calculations don't always give the right answer, in asset valuation, solar power savings estimates or other endeavors. But they're often essential to framing the right questions. Such as: What discount rate does the California Energy Commission use in calculating the present value of future energy savings? According to the commission's latest "Time Dependent Valuation of Energy for Developing Building Efficiency Standards" report, it's 3 percent. That's less than the 30-year mortgage rate, but the lower rate makes sense given that they're estimating the future savings in current dollars, not in inflated future dollars, whereas mortgage rates factor in an estimate of future inflation.

The estimated average future savings add up to about $30,000, the present value of that is $19,000, and that's twice the present cost. This sounds pretty advantageous for California homebuyers. It's most advantageous if you're buying in sunny and often scorchingly hot Palm Springs or points south and east (aka California Climate Zone 15), where the average estimated electricity cost savings per new house is $33,911, and least advantageous if you're buying just over the mountains in San Diego (Climate Zone 7), where the estimated cost savings is only $15,900 because it gets foggy in the mornings and the mild climate keeps home energy use down. But it seems like a pretty good deal all around.

Another big variable in this particular present-value calculation, though, is the future path of electricity prices. The California Energy Commission makes periodic forecasts, and it seems pretty transparent about the assumptions involved. Energy economist Severin Borenstein of the University of California at Berkeley complained last week that "the savings calculated for the households are based on residential electricity rates that are far above the actual cost of providing incremental energy." But if electricity prices go down — and requiring solar panels on virtually every new house in California may push them even further in that direction — then, well, energy costs will be lower. As a matter of public policy, it may be better, as Borenstein urges, to focus resources on large-scale solar generation instead of rooftop installations. But for people buying new houses in California, it seems like they'll be paying a lot less for electricity in either case.

It is true that many, perhaps most of us, intuitively discount the future in ways that don't comport with standard present-value models. This has come to be known in the behavioral economics literature as "hyperbolic discounting," the idea being that the discount rate in your personal present-value calculation might start out low but rises sharply after a year or two before settling down again in the distant future. If your discount rate is 3 percent for the first two years and 15 percent after that, $30,000 in energy savings evenly allotted over 30 years has a present value of just $4,341. In that case, you would find the new California rule to be a travesty. You would also be, how shall we put it, a little bonkers. Sometimes it makes sense for the government to step in and wrest such decisions from individuals' hands, as it does with Social Security. Sometimes it doesn't.

Which side of that line does the California Energy Commission's decision — which also involves considerations of air pollution, climate change and energy reliability — fall on? Really, I don't know, and I could have arrived at that same unhelpful conclusion without a tutorial in present-value calculation. But wasn't it more fun this way?

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Justin Fox is a Bloomberg Opinion columnist covering business. He was the editorial director of Harvard Business Review and wrote for Time, Fortune and American Banker. He is the author of "The Myth of the Rational Market."