Cost Benefit Analysis

1. Cost Benefit Analysis EWG Study Tour, Galway, 18/09/2006

2. Structure • What is Cost Benefit Analysis (CBA)? • Some key features • Where is it used? • Process Issues in CBA • When is it done? • Who does it? • Identification of costs and benefits • externalities

3. Structure (continued) • CBA in different sectors • Transport (worked example) • Environment • Productive investment • Risk and uncertainty • Discount rate • Measures of project benefit • Conclusions • Group exercise

4. What is CBA? • A project appraisal technique • Used to assess net value of project to society • And/or to rank competing projects within programme • The cost-benefit analysis question • Would society be better-off? • Do economic benefits exceed cost of resources?

5. CBA: Key Features • Scope: all costs and benefits • Option analysis • Quantification and monetization • Technique of choice for appraisal of large public investment projects • But other techniques often necessary • Financial analysis, CEA, MCA

6. Where is it used? • Policies, programmes or projects (UK Green Book) • Project level is main use • Mandatory for EU projects >€50 mn. • Infrastructure • Large productive investment • Often used in conjunction with other techniques

7. Process Issues: Timing • CBA should support decision making • Do CBA before political commitments made! • But not before project specification is clear • May need to re-do as more information becomes available • or if costs increase

8. Who does the CBA? • Should not be project sponsor • Ideally commissioner should be independent of project sponsor • Or CBA methodology should be subject of external review • CBA can be manipulated!

9. Identification of Costs and Benefits • First step is to identify costs and benefits • Should be based on programme or project objectives/rationale • Only include those arising as a consequence of project proceeding • Include costs associated with any benefits • Key issues in estimation • Base cba on realistic, not optimistic, projections • Don’t take project sponsors view at face value • Consider possibility of displacement • Consider likelihood of cost overruns

10. Externalities • Externality? • A benefit which third party does not pay for • Or a cost for which they are not compensated • Often provide justification for public investment • Examples • Spillover effects • Congestion or pollution effects • Significant for transport + environment projects • time savings for transport projects • pollution reductions

11. CBA in Transport Sector • Main benefits • Time savings (based on wage rates) • Accident savings (insurance and police costs) • Vehicle operating cost savings • Emission reductions • Costs • Land acquisition • Construction • Maintenance

12. CBA in Environmental Sector • Investments are EU directive-driven • Difficult to put monetary value on benefits • Cleaner water? • Less pollution of rivers and lakes? • Willingness to pay concept • Can estimate value from behaviour • Based on data from other countries • In practice, CEA or basic CBA models used

13. CBA for Productive Investment • Benefits include additional employment and incomes • Direct • Indirect • Induced • But labour resources have a cost • Concept of shadow or opportunity cost of labour • Value of resource in next best alternative use • Market prices normally the best measure of opportunity cost

14. Productive Investment: Treatment of Employment • Shadow cost depends on • were resources previously unemployed? • regional unemployment rate • skill levels etc. • International evidence would suggest minimum of 50% shadow cost • i.e. net benefit only 50 per cent of gross benefit • 80% minimum now used in Ireland • Shadow wage rate for Romania?

15. Risk and Uncertainty • Project outturns always differ from ex-ante estimates • Optimism bias • Risks • Uncertainties • Need to address these factors in appraisal • Optimism bias • At preliminary appraisal stage • Need to adjust costs and benefit assumptions • On basis of experience with comparable projects

16. Discount Rate • Use to convert future values into present value terms • Equivalent to social time preference rate • Don’t use to take account of risk and uncertainty • Currently 4% (real) in Ireland • 3.5% in UK • Romania?

17. Measure of Project Benefit • Need summary measures of project benefit • Net Present Value (NPV) • Internal Rate of Return (IRR) • Benefit-Cost ratio (BCR) • No one right answer • Sensitivity analysis • Check impact of changes in key assumptions • Identify “switching values”

18. Concluding Comments • CBA an important decision making tool • Properly used can help ensure better use of EU funds • But cba technique can be abused • national guidelines needed • shadow wage • discount rate • And possibly central source of expertise

19. Group Exercise • Suppose Tourism Ministry is sponsoring a proposal to allocate structural funds to the construction of a new international Conference Centre in Bucharest • What would be the likely benefits and costs of such a proposal? • How might these be estimated in general? • In reviewing the appraisal, what should the Ministry for Finance be looking out for?