Project Evaluation Methodologies - CBA
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Project Evaluation
Methodologies - CBA
Dr Micheál Collins
mlcollin@tcd.ie
1. Introduction
2. The Role of CBA
3. Some Background
4. Some Guidelines
5. The Approach
6. The Challenges
7. Class Exercise – in groups
8. Some Applications
9. Reading and References
1
1. Introduction
n Definition:
Cost Benefit Analysis (CBA) provides a systematic set of
procedures by which a firm or government can assess
whether to undertake a project or programme and, when
there is a choice among mutually exclusive projects or
programmes, which one to undertake
n In the public sector:
¨ Once a government has decided on the sectoral
distribution of public money, CBA used to indicate
how best to allocate that money among various
opportunities
¨ A framework for incorporating the multitude of
considerations that arise in assessing the desirability
of projects
¨ Go beyond qualitative analysis to quantitative
analysis
2The logic of CBA:
¨ value the benefits to society: economic and social
¨ value the costs to society: economic and social
¨ adjust these for time
¨ combine the costs and benefits and conclude
• if project worthwhile
• which alternative to choose …
2. The Role of CBA
n reduce and control the number of variables faced by a
decision maker and thereby enable more rational
choices …common monetary scale (€)
n ensure that societies resources are put to their most
highly valued uses
n achieve economic efficiency
n evaluate what the market omits: the perspective of
society
3Overall the general principal of CBA:
“to assess whether or not the social and economic
benefits associated with a project are greater than its
social and economic costs”
Department of Finance (2005:38) Guidelines for the
Appraisal and Management of Capital Expenditure
Proposals in the Public Sector
3. Some Background
n Theoretically:
¨ Welfare Economics…the optimal outcome for society
n Historically:
¨ 1844 Italian/French Economist Emile Dupuit
De la mesure de l’utilité des travaux publics
¨ First applied – 1936 US Flood Control Act
¨ Major advance – 1943 John Hicks on consumer
surplus
¨ Used until the late 70s and early 80s – decline and
subsequent revival
4Why the decline?
¨ wider disillusionment with piecemeal state intervention
…evolution of structural adjustment
¨ decreased role for the state
¨ no longer assumed that state will always pursue social
goals
Recovery:
¨ structural adjustment is not complete answer
¨ Regan 1981 – CBA for all major regulation rules
¨ the growth of large scale projects…transport
¨ awareness of environmental issues
¨ private sector applications
4. Some Guidelines
n Will refer to these throughout
¨ Department of Finance Capital Investment guidelines
¨ CSF Evaluation Unit – CBA Working Rules
¨ Sectoral guidelines: Transport, Health
¨ Other references: policy & academic
n Irish Government guidelines insist:
¨ capital spending in excess of €30m requires a CBA
55. The Approach
n Many opinions on how to do a CBA
n Key references are:
¨ Department of Finance (2005)
¨ UK Treasury Green Book
¨ Boardman et al (2006)
¨ Plus:
n Department of Transport (2004)
n Department of Finance (2009)
n Overview of 8 major steps to follow when
carrying out a CBA
The Major Steps:
Step 1: Defining objectives and boundaries
Step 2: Identifying alternatives
Step 3: Identifying constraints
Step 4: Estimating costs and benefits
Step 5: Adjusting the values of costs and benefits
Step 6: Calculating the decision criteria
Step 7: Sensitivity analysis
Step 8: Make a Recommendation
6Step 1: Defining objectives and
boundaries
n At the outset it is crucial to specify the
objectives of a project
n These should be as explicit, precise and
amenable to measurement as possible
(SMART)
n Why?
¨ allows the possibility to identify alternatives
¨ facilitates assessment of the costs and benefits
¨ makes easier to identify for whom benefit is
intended
n Examples / Multiple objectives: explicit and
ordered
n The boundaries or scope of the project are also
important
n local and national perspectives
¨ Examples: new train line
n Time issue – how long do we look?
¨a bridge / train line
¨ forestry
n Overall: a clear indication of what the project is
about and its scope
7Step 2: Identifying alternatives
n Prepare a list of the range of actions which
government could possibly take to achieve the
identified objectives
n Normally include:
¨ “do-nothing” option
¨ “do-minimum” option
¨ private sector option
n Big programme: wide range considered, then
short-list chosen for detailed appraisal…how?
n Care in short-listing: reasons recorded for each
exclusion
Step 3: Identifying constraints
n These take several forms:
¨ Budgetary constraints
¨ Environmental constraints
¨ Production constraints
¨ Legal constraints
¨ Policy constraints
¨ Distributional constraints
n Those relevant must be borne in mind when
appraising a programme
8Step 4: Estimating costs and
benefits
A few points on step 4:
n Idea is to calc all the costs and benefits, add them
together and see which programme gives the greatest
benefit
n important not to be “spuriously accurate”
n normally look at C&B over lifetime of prog.
n normally based on market prices…opportunity cost
n wider social and environmental C&B must be included
(no mkt price available)
Estimating costs and benefits
n Where mkt prices exist (accurately reflect…)
then analysis is straightforward
n But often
(i) Market prices are misleading
(ii) Market prices are not available
n When and what to do…
9(i) Market prices are misleading
n distorted …poor indicators of social c&b’s
n classic reason: imperfect competition
¨ higher P and lower Qty than in perfect competition
n others: price supports, subsidies, taxation…
n Solution is:
¨ shadow prices
¨ willingness to pay estimates
Shadow prices
§ construct artificial prices known as shadow prices
§ it is the value of an input or output to the economy as
a whole
§ in effect, the opportunity cost
§ sometimes established via an assessment of
willingness to accept
§ But, complex and care in use
§ Department of Finance health warning! (2005:39)
10Willingness to pay
§ the amount that individuals are willing to pay to
receive the benefits
§ reflected in the D curve
§ logic: willingness to pay for a little more of a service is
a reflection of the value placed by consumers on an
increment of that service
§ € amount can vary across income groups; average is
used
§ collected via: stated or revealed preferences
(ii) Market prices are not available
n In some cases there are no market prices
n for: public goods, externalities, intangibles
n Values obtained indirectly
n Some examples:
¨ the value of time
¨ the value of life
¨ the value of environmental externalities
11The value of time
§ Time savings = major benefits of transport initiatives
§ “time is money”
§ Assumption that: the wage rate provides a measure
of an individual’s evaluation of their own time
§ Labour v leisure
§ a value is inferred or revealed given an individuals’
life
§ Basic ideal: if new motorway reduces commuting
time by 20 mins and hourly wage rate for a person is
€15, then value of saving to that person = €5
Some considerations:
§ labour market conditions and the value of marginal
gains in time…shadow price of labour
§ small savings of time by many people may amount
to a lot but be valued very little
§ value different depending on when you save the
time
§ working time v leisure time
§ and where you save the time
§ leisure v walking v waiting
12Department of Transport – 2002 values
see course website for document
¨ Work time = €26.50 per hour
¨ Non-work:
Non-work Walk (x2) Waiting (x2.5)
Commuting €8.10 €16.20 €20.25
Non-Commuting €7.30 €14.60 €18.25
¨ They provide inflators to update values to today’s terms
¨ Critique of these time values – to discuss
The value of life
§ ‘Value of a statistical life’
§ Most controversial aspect of CBA
§ distasteful but highly relevant
§ healthcare projects, transport improvements, road
safety campaigns…
§ 3 approaches
13§ First, foregone earnings
§ estimate what individual would have earned had he
remained alive (until “normal” age of death)
§ use employment history and case-studies
§ used by courts
§ problems:
§ fails to distinguish between value of life and livelihood
§ low-paid worth less than well-paid
§ how much will a child earn?
§ retired = €0 value
§ Second, wage premiums for risk
§ calculate the value of life by analysing how much extra
income is needed to compensate people for an
increase in risk to life
§ Gardai v clerical workers
§ form of revealed preference
§ put another way: what are people willing to pay to
avoid or reduce their risk of fatality
§ approach favoured by economists
§ problems:
§ people can be poorly informed about their risk
§ wealth factor: poor accept risk premium, rich do not
14§ Third, contingent valuation of life
§ the most recent
§ survey of individuals asking a series of q’s intended to
elicit how they behave under levels of risk
§ from results can calculate how they value life
§ use this value in CBA
§ EU DG Environment uses €1m (2000 prices) as a base
value and makes adjustments to this figure for age, risk
exposure etc
§ Lower estimate = €0.65m; Upper estimate = €2.5m
Example of Contingent Valuation of Life
n suppose population of 10,000 people
n survey (sample) to establish willingness to pay for an
airbag in their car
n answers vary…on average €250
n total for population: €250 x 10,000 = €2.5m
n say airbag reduces fatal accidents by probability of 1 in
10,000
n Therefore, society willing to pay €2.5m to save a life
n Have established a value
15Irish Values (2002 basis):
n Department of Transport document (2004)
n Statistical value of a life saved
¨ plus accidents avoided
¨ plus injuries avoided
n There are other values used
¨ healthliterature and broad ranges
¨ World Bank…
Irish Values (2002 basis):
16The value of environmental externalities
§ literature continually developing…1989 Exxon Valdez
oil spill in US
§ 2 methods in brief
§ First, revealed preference approach
§ Simple example
§ 2 houses with same features located in different areas
§ one areas has clean air, the other is polluted
§ house in clean area will sell for higher price
§ the difference in price = value of clean air
§ Second, contingent valuation
§ a new technique
§ US application post 1989 Exxon Valdez oil spill
§ survey of individuals asking a series of q’s intended to
elicit how much they value environmental damage or
the preservation of a species
§ sum results together to get value to population
§ small values total to big results
§ use this value in CBA
17§ Pricing emissions
§ require calculation of the impact of a project / policy on
emissions
§ if can’t calculate then quantity is estimated / modelled
§ expressed in either carbon savings or additional
emissions
§ measured in tonnes of carbon-dioxide equivalent (C02e)
§ link to carbon credits; carbon markets and Kyoto fines
§ Exchequer cost…
Department of Finance June 2009
§ new development
§ document on the course website
§ require inclusion of C02e in CBA and other project
appraisals
§ values provided and to be updated annually
§ scope: only direct C02 emissions from within state
jurisdiction and not already accounted for
n “the resources used to estimate C02e emissions should
be proportionate to the scale of the project”
n June 2009 prices:
18June 2009 values:
§ Pricing noise pollution
§ Dept of Finance June 2009:
“Departments/Agencies should consider sector
specific emissions, such as noise, air quality (NOx,
SOx, particulate matter), and vibrations in addition
to C02e emissions and where relevant, possible
and significant include these costs/benefits in the
CBA”
19§ calculation of the impact of noise as a result of a
project / development
§ e.g. new transport infrastructure (airport), industrial
development, traffic plans…
§ measured as increase or decrease in noise levels in
average decibels (dB(A))
§ Across EU values range €20-€30 per household per
decibel per year
§ Median value is €23.50 (2001 prices)
20Step 5: Adjusting the values of
costs and benefits
n Four adjustments to consider
(i) Present values
(ii) The social discount rate
(iii) Real Prices
(iv) Distributional issues
21(i) Present values
§ costs and benefits occur in different time periods
§ “time preference”: people prefer to receive goods
and services now rather than later
§ calculate the present value of costs and benefits
§ use the interest rate (i)
§ if the i rate is 5%, the present value of a benefit of
€105 next year is €100
§ You discount the future value by a value between
0-1, known as the discount rate or discount factor
§ Formula to calculate it…
§ Discount factor formula:
i = the interest rate
n = the number of years time the amount accrues
1
Discount factor =
(1 + i ) n
See Handout – copy of table from UK Green Book
22(ii) The social discount rate
§ Just like people, society likes to receive goods and
services now rather than later
§ tend to use a different discount rate to that used by
the private sector
§ called the social discount rate
§ Why?
§ society takes a longer perspective, not as much rush for
returns
§ market rates contain a risk premium, state is less risky
§ Department of Finance: 4% in real terms
§ See Handout – Dept of Finance July 2009
(iii) Real prices
§ Future costs and benefits need to be adjusted for the
effect of inflation
§ compared at ‘constant prices’ or in ‘real terms’
§ deflate all future values by the expected inflation
value
§ Annual figure from Dept of Finance
§ “2% per annum over the medium to longer term”
§ See circular from July 2009 - Handout
23(iv) Distributional issues
§ How are the costs and benefits distributed?
§ if person A gains €200 and person B looses €100:
overall society gains but if person B was poor and is
now poorer?
§ possible to take into account distributional issues by
attaching weights to the benefits and costs
§ benefits to disadvantaged groups weighted more than
those to the better-off
§ but, define these groups; which weights to use?
§ seldom used
§ alternative = compare inequality pre and post policy
n Overall:
§ Adjust the costs and benefits to present values by:
§ adjusting for inflation
§ and discounting using the social discount rate
24Step 6: Calculating the decision
criteria
n Once our calculations are complete, how do we
interpret the final result?
n 3 decision criteria
(i) net present value (NPV)
(ii) internal rate of return (IRR)
(iii) benefit-cost ratio
(i) net present value (NPV)
§ costs are subtracted from benefits and the net
benefits are expressed at their present value
§ if NPV is positive then project is accepted
§ if NPV is zero then project is indifferent
§ if NPV is negative then project is rejected
§ projects with positive NPVs enable efficient allocation
of resources and represent an improvement to the
welfare of society
§ competing projects: choose one with highest NPV
25(ii) internal rate of return (IRR)
§ the discount rate that will make the NPV of a project
equal to zero
§ a project is worthwhile if the IRR is greater than the
discount rate used
§ an IRR of 15% means that at a discount rate of 15%
the project just breaks even; it could earn back all the
capital and operating costs and pay 15% for the use
of the money
§ problem: not good for comparing competing projects;
does not account for the size of the project
(iii) benefit-cost ratio
§ ratio of discounted benefits to discounted costs
§ a project is accepted if BC ratio > 1
§ more benefits than costs
§ problem: misleading if used to rank projects as it
ignores the size of the project
26n Of the three decision criteria, the NPV approach
is considered:
¨ the most reliable method
¨ and the best method to use
Step 7: Sensitivity analysis
n CBA’s are performed ‘ex-ante’
n always likely to be some difference between
what is expected and what eventually happens
n need to take these uncertainties and risks into
account
n key approach = sensitivity analysis
¨ involvesrecalculating the NPV at different values for
parameters
n if i rates were higher
n if wages rates grew by 10% and not 5%
n if revenues were lower than expected
27n primary variables that are uncertain:
¨ the discount rate
¨ wage rate growth
¨ forecast revenues
¨ forecast demand
¨ input prices
¨ input quantities
¨ project life span
¨ C02e values
n performing this: pinpoint areas of risk to project
Step 8: Make a Recommendation
n Based on the analysis and the sensitivity
testing…
28Summary: The 8 Major Steps
Step 1: Defining objectives and boundaries
Step 2: Identifying alternatives
Step 3: Identifying constraints
Step 4: Estimating costs and benefits
Step 5: Adjusting the values of costs and benefits
Step 6: Calculating the decision criteria
Step 7: Sensitivity analysis
Step 8: Make a Recommendation
6. The Challenges
n Appropriate short-listing
n Establishing prices
¨ shadow prices
¨ shadow price of labour
¨ relying on willingness-to-pay techniques…subjective
n Borrowing and the shadow price of public funds
n Over optimism & intentional pessimism
n Avoiding double counting
29n Unquantifiable costs and benefits
§ it may be the case that it is just not possible to
quantify some costs and benefits
§ too difficult; no data available; too much time
involved, no suitable shadow prices…
§ cannot ignore these…give misleading indications
of best project to pursue
§ solution (1): present results in a form which allows
the decision maker to take these into account
§ solution (2): provide a central estimate together
with a max and min plausible valuation
§ solution (3): adopt an alternative methodology that
works without valuing everything
307. Class Exercise – in Groups
n 15 minutes
¨ discuss the possibility of doing a CBA
¨ what are the costs, benefits…
1. National Road Safety Strategy
2. Bus Corridor – Dublin city centre
3. National Swine Flu vaccination campaign
4. Malaria Nets in Africa
n Discussion on each afterwards
8. Some Applications
n Documents on the website
n Guidelines:
¨ Department of Finance Capital Appraisal (2005)
¨ Department of Finance Discount Rates (2009)
¨ Department of Finance CO2 values (2009)
¨ CSF Working Rules for CBA (1999)
¨ Department of Transport CBA values x2 (2005)
¨ UK Green Book x2 (2003)
31n CBA Examples
¨ Road Safety Strategy 1998-2002
¨ Domestic Energy Efficiency
¨ Introduction of Digital TV in UK*
¨ Traffic Light & Speed Cameras in UK
¨ Luas Extensions*:
n Line A1 Belgard to Saggart (2 documents)
n Line B1 Sandyford to Cherrywood
n Line C1 Connolly to Point Depot
n Research Articles
Just to show you these:
¨ CBA Domestic Energy Efficiency
¨ CBA Rural Renewal Tax Break
¨ Contingent Valuation – Irish Public Service
Broadcasting
¨ WTP for Conservation of Rural Landscapes
¨ Shadow Price of Aircraft Noise
329. Reading and References
n Boardman et al – CBA Steps (Handout)
n Various guidelines – as referenced in class
(website)
n Example CBAs – as referenced in class
(website)
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