5.42 The valuation of costs or benefits should be expressed in 'real terms' or 'constant prices' (i.e. at 'today's' general price level), as opposed to 'nominal terms' or 'current prices'.
5.43 If necessary, the effect of expected future inflation in the general price level should be removed by deflating future cash flows by forecast levels of the relevant deflator. Over a long-term period, the Bank of England's annual inflation target6 is the appropriate measure of prices to use as a general deflator.
5.44 Where particular prices are expected to increase at significantly higher or lower rate than general inflation, this relative price change should be calculated. Examples where relative price changes may be material to an appraisal include:
❑ High technology products, prices for which may be expected to fall in real terms;
❑ Fuel prices, where the resource supply is scarce; and
❑ Wages, where productivity growth is expected to lead to wage increases above general inflation.7
5.45 It is helpful when anticipating relative price movements, to consider whether the value of a benefit or a cost will rise as incomes increase. The most direct evidence for this is evidence about how, in fact, revealed preference or stated preference valuations of the benefit in question have increased with income over time. In some cases there is reason to expect that the value of a benefit or cost will rise as incomes increase, for example because the good is in fixed supply (such as certain environmental assets), or because the units in which it is measured are such that its utility value can be expected to remain broadly constant, regardless of changes in income. In the absence of definitive data, the rate of increase in the real value of the benefit should be assumed to be positive, and only in unusual circumstances would it exceed the projected rate of increase of per capita real income.8 Where these assumptions are critical, they should be tested against any specific evidence.
5.46 For other costs and benefits, the factors listed below might be considered in determining whether their value would change by more or less than inflation.
❑ Scarcity. If a good is exhaustible, its relative price may be expected to rise at a faster rate than general prices, as it becomes increasingly scarce. Against this, developing technologies may enable more of a good to be extracted than initially thought possible.
❑ Substitutability. Where plenty of substitutes are available, any scarcity impact may be largely offset. Consideration should be given to whether substitutes are likely to develop over time, particularly in the case of exhaustible goods.
❑ Non-linearity. Some of the damage resulting from pollutants, for example, will be non-linear. If the quantity of a pollutant changes over time, this non-linearity will affect the rate at which its relative price changes.
❑ Increasing competition, or the removal of monopoly powers, would increase the availability of goods and services, and relative prices may be expected to decline.
❑ Economies of scale. If the size of the market for a particular good or service increases, then there is a greater potential for economies of scale, and relative prices may then also be expected to reduce.
5.47 Advice on likely relative price movements should be obtained from the appropriate expert bodies and from finance divisions or economists.
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6 Currently set by the Government at 2.5%.
7 HM Treasury (2002),'Trend Growth: Recent Developments and Prospects', projected trend productivity growth of 2%
8 Any reduction in the discount rate in the longer term should be linked to a proportional decrease in the projected rate of growth of income.