Capacity Building On Regulatory Review Impact Analysis Module ‘ Applying cost benefit analysis to regulatory proposals’

1. Capacity Building On Regulatory ReviewImpact Analysis Module‘Applying cost benefit analysis to regulatory proposals’21-25 March 2011 Rod Bogaards Productivity Commission Australian Government

2. Some things just don’t add up!

3. A sobering thought … • There are significant challenges in using CBA • Mainly because it is inherently difficult to accurately measure benefits and costs in dollar terms • But even when it is difficult to measure benefits and costs with any precision, applying the CBA framework is important and useful

4. Questions to be addressed • What is Cost Benefit Analysis (CBA)? • When did Australian Governments develop a heightened interest in CBA? • Why is CBA useful? • Where does CBA fit into the RIS/RIA process? • When should you conduct CBA? • What are the basic steps in conducting CBA? • What services could be provided by a CBA Unit?

5. What is Cost Benefit Analysis? • CBA is an analytical tool used to assess the benefits and costs of regulatory proposals • Given sufficient information, CBA can: • calculate the net benefits for each proposal • rank proposals by their net benefits • recommend the proposal with the greatest net benefit

6. When did Australian Governments develop a heightened interest in CBA? • Government decisions of 2005/2006 gave renewed focus to CBA • Implications: • government agencies need to build their capacity to use CBA to improve the quality of regulatory impact analysis • greater use of CBA expected by governments for regulatory proposals

7. Why is CBA useful? • CBA examines costs and benefits from the perspective of the community as a whole: • it forces a wider view on decision makers • promotes comparability and encourages consistent decision making • its aim is to maximise community net benefits • CBA includes all costs and benefits – it tells the whole story

8. Why is CBA useful? • CBA provides a summary of the efficiency effects of a policy • But CBA can draw attention to equity issues • by identifying who gains and who loses from a regulatory proposal • but it is up to decision makers to decide whether distributional impacts/equity issues are important and need addressing

9. Where does CBA fit into the RIS/RIA process? • Problem • Objectives • Options • Impact analysis • Consultation • Conclusion and recommended option • Implementation and review

10. When do you need to conduct CBA? • Should be a greater focus on valuing impacts in dollars for regulatory proposals, particularly those with ‘significant’ impacts • But non-monetised costs and benefits should not be excluded from consideration in CBA • Impacts should be reported in CBA as follows: • monetised • quantified, but not monetised • qualitative, but not quantified or monetised

11. Existence of non-monetised costs and benefits presents a challenge • Agencies should consider non-monetised impacts adequately but not overplay them • If a proposal shows large monetised ‘net’ costs the onus is on the government agency to clearly explain why non-monetised benefits would tip the balance

12. What are the basic steps in conducting a CBA? • Specify the set of policy options • Decide whose costs and benefits count • Catalogue the impacts and select measurement indicators • Predict the impacts over the life of the regulatory proposal

13. What are the basic steps in conducting a CBA? • Monetise (attach dollar values to) impacts • Discount future costs and benefits to obtain present values • Compute the net present value for each policy option • Perform sensitivity analysis • Rank the policy options

14. 1. Specify the set of policy options • Specify the set of policy options to solve a problem • One of the options should always be ‘maintain current arrangements’ • The number of potential options can be large • Analysts typically analyse only a few feasible options (usually < 6)

15. 2. Decide whose costs and benefits count • Usually only take account of costs and benefits at the national level – from the Malaysian community’s perspective • Some argue costs and benefits to non-nationals should also be included for international/global issues • However, for most regulatory proposals, measuring national costs and benefits is appropriate

16. 3. Catalogue the impacts and select measurement indicators • Identify the full range of impacts of the regulatory proposal • Identify incremental costs and benefits relative to the base case (i.e. ‘maintain current arrangements’) • Changes that would have occurred anyway should not be attributed to the regulatory proposal • Choice of measurement indicator depends on data availability and ease of monetisation

17. 4. Predict the impacts over the life of the regulatory proposal • Impacts should be quantified for each time period over the life of the regulatory proposal • Prediction of future impacts is difficult – there will always be some uncertainty surrounding the outcome of a regulatory proposal • Forecasts of costs and benefits require some assumptions to be made – these should be justified and made transparent

18. 5. Attach dollar values to all impacts • We measure costs and benefits in dollar terms to enable comparisons to be made • Analysts must estimate impacts in a variety of circumstances: • competitive markets • distorted markets (e.g. externalities) • no market signals (e.g. human life) • Problems arise where markets do not work well or do not exist - in these cases techniques are available to estimate impacts • revealed preference techniques • stated preference techniques

19. 6. Discount future benefits and costs to obtain present values • Costs and benefits of regulatory proposals are spread out over time • Positive market interest rates indicate that people value a dollar in the future less than a dollar now • To reflect this, future benefits and costs are discounted to present values which expresses them as an equivalent amount in today’s dollars • The OBPR’s preferred approach is to base the discount rate on market-determined interest rates and suggests using a real discount rate of 7%

20. 7. Compute the net present value of each alternative policy option • Net Present Value (NPV) is equal to present value of benefits minus present value of costs: NPV = PV(B) – PV(C) • If all costs and benefits cannot be valued in dollars, outline why non-monetised impacts are large or small relative to monetised impacts

21. 8. Perform sensitivity analysis • There is usually considerable uncertainty about predicted costs and benefits • Sensitivity analysis shows how these uncertainties affect the CBA results • Three types of sensitivity analysis: • worst/best case analysis • partial sensitivity analysis • Monte Carlo sensitivity analysis • If the sign of the net benefits does not change after considering the range of scenarios, there can be confidence in the CBA results

22. 9. Rank the policy options • The analyst should specify which option is the most efficient • Generally, it will be the one with the largest NPV • The recommendation should be clearly presented

23. CBA accuracy • The usefulness of CBA depends on its accuracy • Accuracy depends on how well the analyst performs the nine steps • Each step is subject to errors but most important errors occur in steps 3, 4 & 5 relating to: • specifying the cost and benefit categories • predicting the costs and benefits • valuing the costs and benefits in dollars

24. Common CBA pitfalls • Downplaying or ignoring non-financial social benefits and costs • Double counting benefits • ‘Before/after’ rather than ‘with/without’ • Selecting a discount rate to deliver a particular result • Ignoring uncertainty – no sensitivity analysis

25. Consider the counterfactual – ‘with and without’ Net benefits With regulation Without regulation Time Regulation introduced

26. Determining impact valuations from secondary sources • Obtaining valuations is time consuming and resource intensive • Least-cost approach is to use previously estimated valuations – don’t have to reinvent the wheel • Refer to such estimates as ‘plug-ins’ or ‘benefits transfer’ or ‘information transfer’ • Although catalogues of impact values are not comprehensive, considerable progress has been made

27. Frequently used ‘plug-ins’ include: • Value of a statistical life or life year • Value of travel time savings • Value of recreational activities • Value of nature (species or habitats) • Cost of noise pollution • Cost of air pollution

28. Valuing mortality risk reduction or the value of a “statistical” life (VSL) • How much would individuals pay to achieve a small reduction in the probability of death? • Revealed preference and stated preference studies can provide estimates of willingness to pay for small changes in mortality risk

29. VSL is not the value of an ‘identified’ life! • VSL is the aggregate amount that a group of individuals are WTP for a risk reduction • If people are WTP, on average, $12 for a risk reduction from 5 in 500,000 to 4 in 500,000 • VSL = $12/0.000002 = $6 million • It does not mean that an individual would pay $6m to avoid (certain) death this year • It does imply that 500,000 similar people would together pay $6m to eliminate the risk that is expected to kill one of them randomly this year

30. No set formula for attaching dollar values to impacts • High quality analysis may require professional expertise – consultants can be useful • Different impacts may call for different estimation techniques • Will depend on the nature and complexity of issue and availability of information

31. CBA should be undertaken for all ‘significant’ regulatory proposals • Definition of ‘significant’ requires some judgement • Scale of CBA should be commensurate with magnitude of problem • Agencies should devote more resources to problems where stakes are greater

32. Preparing proposals with a greater focus on quantification: key challenges • Proper resourcing • Getting the right skills • Collecting high quality information • Consulting with stakeholders

33. What services could be provided by a CBA Unit? • Providing assistance on technical issues • Advising how to improve CBA done in-house or undertaken by a consultant • Training/Workshops on CBA • Developing CBA guidance material on a ‘needs basis’ • Repository of CBA reports

34. And remember… • Even though many RIA systems require CBA the proportion of RIA that actually manage to fully quantify costs and benefits, and produce a robust NPV result, remains relatively small • But don’t despair, even if some costs and benefits remain unquantified, applying the CBA framework provides a very good discipline when examining regulatory proposals

35. Useful CBA References • Office of Best Practice Regulation 2010, Best Practice Regulation Handbook (Appendix E), June. • Commonwealth of Australia 2006, Handbook of Cost Benefit Analysis, January. • Boardman, E.A., Greenberg, D.H., Vining, A.R. and Weimer, D.L. 2006 Cost-Benefit Analysis: Concepts and Practice, 3rd edition. • OECD 2006, Cost-Benefit Analysis and the Environment: Recent Developments

36. Key messages • CBA is a pragmatic tool for drawing attention to the likely impacts of regulation • Quantifying costs and benefits is challenging but not impossible (given sufficient time, skill and resources) • CBA can play an important role in improving the quality of regulatory proposals – even when valuation is difficult