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Cost benefit analysis - key features and future directions

Posted February 11, 2016

SGS Economics and Planning CBA key features

Cost-Benefit Analysis (CBA) has played a critical role in public policy for more than 50 years. CBA goes beyond financial analysis which considers direct monetary costs and revenues. It instead, enables policymakers to assess whether a policy initiative or project will provide a net community benefit. CBA also takes into account that the (limited) resources deployed in implementing the initiative or project have alternative productive uses.

The power of CBA as an analytical tool rests in two main features:

  • Costs and benefits are, as far as possible, expressed in monetary terms and hence are directly comparable with one another.
  • Costs and benefits are evaluated in terms of the claims they fulfilled, and the gains they provided, namely the triple bottom line as a whole. The perspective is 'global' or society-wide, rather than that of any particular individual, organisation, or group.

CBA is regularly applied to evaluate the economic merits. These include policy proposals, plans, and projects, during business case preparation, regulatory impact assessments, and evaluation of strategic planning options. With this in mind, everyone concerned with the public policy can benefit from being aware of the key features of CBA and importantly, its limitations and how it may evolve.

Key features of cost-benefit analysis

CBA has a few defining characteristics.

First is the need to identify a 'business as usual' scenario and one or multiple 'with project' scenarios. The CBA attempts to value the difference in outcomes between these scenarios. And therefore, the impact of moving from ‘business as usual’ to a different, project-based future.

Secondly, the CBA needs to identify the range of economic, social, and environmental costs and benefits that it may expect in moving from the 'business as usual' to 'with project' scenarios. A 'business as usual' scenario will still involve some changes, and these too need to be considered. It is the marginal change only that is under evaluation.

The third is the quantification of costs and benefits. It is possible to draw accurate estimates of monetary value for 'traded' costs and benefits from capital outlays, operation expenditure, and revenue forecasts associated with similar projects.

For the non-traded costs and benefits, namely the negative and positive 'externalities', economists need to derive proxy monetary values to use in the analysis. Established techniques exist for this. In particular for costs and benefits associated with travel or where the impacts translate into falling or rising property prices in the project's vicinity. However, it is still necessary to make assumptions to derive these 'non-traded' values. Many impacts will be difficult, if not impossible, to quantify. It is important to be explicit about assumptions along with the quantifiable and non-quantifiable costs and benefits.

A crucial fourth feature of CBA is that costs and benefits are allocated over a suitable project evaluation period, typically 25 years. Initial costs are usually associated with preparation and then construction. Revenues and benefits tend to flow once the project is up and running.

Finally, CBA generates performance measurements using discounted cash flow techniques over the life of the project-related costs and benefits. All values are expressed in 'present-day dollars' using a 'discount rate.' Essentially, this makes an allowance for the fact that typically, a dollar's worth of benefit received today has a higher value than a dollar's worth delivered some years hence. As if we have the dollar today, we can invest it to earn interest in the future.

Departments of Treasury provide guidance on the appropriate 'discount rate' to use. They typically cite three performance measures. Firstly, net present value (NPV), which is the summing of all costs and benefits expressed in present-day values. Secondly, benefit-cost ratio (BCR), which is the sum of benefits divided by the sum of costs expressed in present-day values. Finally, internal rate of return (IRR) which is the percentage return (of benefits) on the costs invested (technically, the discount rate which forces the NPV to equal zero). The performance measures should be subject to 'sensitivity tests.' These tests involve modifying the underlying assumptions to determine the variables which have a particular impact on the findings.

A sound CBA also involves discussion or description of the costs and benefits that cannot be readily quantified. As noted, CBA focuses on net community benefit. In effect, a project is worthy of investment providing project beneficiaries are able to compensate the losers while remaining in positive territory, irrespective of whether they're called upon to do so. Despite this focus, decision-makers are often interested in the equity of the spread of costs and benefits throughout societal and geographically defined groups. The question at this point is, are there particular parts of the State or country, or specific economic groups, who are disproportionately affected by the project? To answer this question requires a parallel evaluation, using either quantitative or qualitative techniques.

Some systemic problems with CBA

Correctly applied, CBA is a rigorous technique for evaluating projects competing for limited public sector resources. That is not to say that it doesn’t have its limitations and failings. Some, such as the difficulty of quantifying non-traded costs and benefits, false accuracy, and overlooking equity, arise from the poor understanding or application of the approach. Whereas others are systemic failings.

These systemic failings all relate to an aspect at the heart of CBA, which is the idea of discounting future costs and benefits. Typically, the discount rate chosen (approx. 4-10%) means that costs and benefits beyond 25-30 years are 'discounted' to a point where they have a negligible impact on the benchmark indicators. Conventional cost-benefit analysis, therefore, tends to heavily 'discount the future.' Particularly so in the case of benefits which continue to flow into the future, well after incurring the most significant costs. For major infrastructure projects which have the potential to re-shape the city for generations, or projects with a significant future environmental payoff, this is problematic.

In the practice of 'discounting the future,' CBAs typically apply a common discount rate across all items. This discount ignores the fact that some benefits may increase in their 'real' value over time. For example, vegetation with threatened bio-diversity values, rare heritage items, unique cultural assets, and public transport networks provide a dependable and lower-cost alternative to roads that are becoming more congested. A rigorous approach would be to apply minimal discount rates or in some cases, negative rates, to account for the different intergenerational values attributed to such items. Justifying and providing evidence supporting the use of variable discount rates is onerous. The generally accepted approach is to use a common, relatively high discount rate. This approach is often to the detriment of an effective evaluation of projects with long-term benefits.

A further related failing is the limitation of CBA in scope to 'first-round impacts'. CBA is evolving rapidly. The range of impacts taken into account is extending more broadly than direct user benefits and a limited range of obvious environmental externalities. However, it is conventional in cost-benefit analysis to restrict measured impacts to the 'first-round effects' of projects. While these may be subject to lags, they have a direct 'cause and effect' link with the infrastructure item in question. Indirect and feedback effects are excluded, mainly for practical reasons. When taking second and subsequent round benefits into consideration, it is also necessary to include cost. Thus making the data gathering and analysis process very complicated and open to challenge due to multiple judgements being required to identify the effects.

SGS Economics and Planning CBA Sydney

Arguably, an example illustrating the weakness of CBA is the Sydney Opera House. This project would undoubtedly have fallen short against conventional CBA benchmarks. A sophisticated application of the technique may have identified some additional visitation and expenditure to Sydney generated by its iconic architectural status. However, it would have been a challenge to measure the reverberating and enduring benefits for the city from the sense of pride that it delivers to its residents. Importantly, the strong imagery it provides for Sydney as a global city, and the subsequent additional investment it has attracted.

As with the Opera House, it is unlikely a conventional cost-benefit analysis would ever have generated the benchmarks to justify the Sydney Harbour Bridge as a transport project. The lead-in period of planning, loss of life during construction, and immense up-front investment may have been possible to anticipate. The CBA would have taken such analysis into account with a trickle of benefits, related primarily to faster travel times, over the 20-30 year project period. Longer-term benefits, though, would not have been included.

One such benefit is the gradual increase in business formation and productivity. As enterprises better connect, they're able to source the skills needed to grow employment centres and residential areas on both sides of the harbour. Add to this the long-term deferral of future costs due to the provision of sufficient capacity for 50 years of growth. In comparison, consider the M5 East, which although opened less than ten years ago, is already at capacity. Conventionally applied, CBA would be incapable of including the long-term and 'second round' benefits of either project.

Future directions

There is a need for CBA to evolve further. For major transport projects, advanced CBA might utilise economic modelling which would track long run and 'second round' effects, and link these to land-use outcomes. Deepening the research and evidence base to better track and quantify intangibles will be fundamental to iconic architectural and cultural building projects. These intangibles include pride, amenity impact potential, and potential 'branding' value. When projects have a cultural, heritage, or environmental impact, CBAs ideally need to initiate low or negative discount rates. In particular for items whose value is likely to increase in the future.

There is also a need for improved consistency in application across practitioners. Government-developed guidelines with standard discount rates and default values for certain externalities are helpful. However, economists may report contradictory findings for the same project. Here, peer review and the publication of peer-endorsed methodologies for resource and benefit identification and valuation, have a role to play.

SGS Economics and Planning CBA