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CBA – Theory and Practice

Dr. Andy Park


Senior Economic Adviser
Scottish Government
The views expressed in this lecture are those of the
presenter and do not necessarily reflect Scottish Government
Policy.
Structure
• CBA Theory
– The basics
– Advanced: Hyperbolic discount rates
– Advanced: WTP vs. SCA
• CBA in a multicriteria framework
– Scottish Transport Appraisal Guidance
– Welfare and Growth
– Agglomeration
• Limitations of CBA
– BCR in a WTP framework
– Non-monetarised factors
– Criticisms
The ROAMEF cycle
Appraisal and evaluation
• COST-BENEFIT ANALYSIS
• Analysis which quantifies in monetary terms as
many of the costs and benefits of a proposal as
feasible, including items for which the market
does not provide a satisfactory measure of
economic value.
• COST-EFFECTIVENESS ANALYSIS
• Analysis that compares the costs of alternative
ways of producing the same or similar outputs.
Cost benefit analysis
• In essence, the costs and benefits of a
proposal or intervention are expressed in
monetary terms in a consistent manner
and the flows of such costs and benefits
over time are discounted to reflect social
time preference.
• The results are summarised in terms of a
Net Present Value and a Benefit Cost ratio
CBA:
• Net Present Value. The NPV is the
discounted sum of all future benefits less
the discounted sum of all future costs over
the appraisal period. In a world with no
constraint on investment funds, there
would be a strong case for taking forward
all projects with a positive NPV.
NPV  NPB  NPC
CBA: Benefit Cost Ratio (BCR)
• Benefit/Cost Ratio. The BCR is given by the ratio:
Net Present Value (NPV) + Present Value of Cost to Public Accounts
Present Value of Cost to Public Accounts
where NPV is as defined above
• The BCR is, therefore, a value for money measure, which indicates how
much net benefit would be obtained in return for each unit of cost to public
accounts. This is clearly relevant in the real world situation of limited funding
available from public accounts.
• A BCR greater than one indicates the project is “worthwhile”.
• It should be noted that the MSCGF (Marginal Social cost of government
funds) that reflects the fact that there is a cost associated with raising
government revenue would indicate that a BBCR greater than 1.3 is
required. This issue is currently not a government requirement.
• Note that the BCR is of limited value where projects (road user charging, for
example) result in significant revenues accruing to public accounts. More on
this later.
CBA: Discounting
• Formally any sum (S) can be reduced to its
present value (PV) by this formula:
PV = S/(1+ r)n
Where r is the discount rate and n is the
number of time periods into the future that S
will impact.
• More generally the discounted value of a stream
of amounts is given by:
t
An
PV  
n 0 (1  r ) n
CBA: Discount rates
• Under HMT Green Book Years from the current Discount
discount rates decline year rate
over time.
• Not strictly speaking 0-30 3.5%
Hyperbolic discount rates
but banded for 31-75 3.0%
convenience.
76-125 2.5%
• Implication is that greater
weight (strictly speaking 126-200 2.0%
less weight but at a
declining rate) is given to 201-300 1.5%
the future than with a
constant rate. 301 and over 1.0%
CBA: Social time preference
• Social Time Preference is defined as the value society attaches to
present, as opposed to future, consumption. The Social Time
Preference Rate (STPR) is a rate used for discounting future
benefits and costs, and is based on comparisons of utility across
different points in time or different generations.
• The STPR has two components:
– The rate at which individuals discount future consumption over present
consumption, on the assumption that no change in per capita
consumption is expected, represented by ρ; and,
– An additional element, if per capita consumption is expected to grow
over time, reflecting the fact that these circumstances imply future
consumption will be plentiful relative to the current position and thus
have lower marginal utility. This effect is represented by the product of
the annual growth in per capita consumption (g) and the elasticity of
marginal utility of consumption (μ) with respect to utility.
• The STPR, represented by r, is the sum of these two components:
r = ρ + μ.g (1)
CBA: Estimates of ρ
• This comprises two elements:
– Catastrophe risk (L); and
– Pure time preference (δ).
• The first component, catastrophe risk, is the likelihood that there will
be some event so devastating that all returns from policies,
programmes or projects are eliminated, or at least radically and
unpredictably altered. Examples are technological advancements
that lead to premature obsolescence, or natural disasters, major
wars etc. The scale of this risk is, by its nature, hard to quantify.
• The second component, pure time preference, reflects individuals’
preference for consumption now, rather than later, with an
unchanging level of consumption per capita over time.
• The evidence suggests that these two components indicate a value
for ρ of around 1.5 per cent a year for the near future.
CBA: Determination of Discount
rate
• Estimates of μ
– The available evidence suggests the elasticity of the marginal
utility of consumption (μ) is around 1.4 This implies that a
marginal increment in consumption to a generation that has
twice the consumption of the current generation will reduce the
utility by half.
• Estimates of g
– Maddison (2001) shows growth per capita in UK to be 2.1 per
cent over the period 1950 to 1998. Surveying the evidence, the
Treasury paper Trend Growth: Recent Developments and
Prospects also suggests a figure of 2.1 per cent for output
growth to be reasonable. The annual rate of g is therefore put at
2 per cent per year.
• So with g = 2 per cent, ρ = 1.5 per cent, μ = 1.0, then
from equation (1) the STPR to be used as the real
discount rate is 0.015 +1.0*0.02 = 3.5 per cent
CBA – SCB Accounting
• The calculus of social costs and benefits seeks
to measure the value of the 'resources' used by,
and the benefits created by, a project.
• This approach distinguishes between social
costs/benefits and transfer payments at the
outset, and takes account only of the former.
• Because the calculus of social costs and
benefits nets out transfer payments, this
approach does not allow the net social benefit of
a project to be disaggregated into impacts on
different economic interest groups.
CBA - WTP
• The basic strategy of the willingness-to-pay (WTP) calculus is to
arrive at a money measure of the net welfare change for each
individual that is brought about by the project under consideration,
and then to sum these.
• The welfare change for any individual is measured by the
compensating variation, i.e. the individual's WTP for benefits or the
negative of his/her willingness to accept compensation for
disbenefits.
• The principle behind this calculus is the Kaldor-Hicks compensation
test: a move from one state of affairs to another passes this test if, in
principle, those who benefits from the move could fully compensate
those who lose (without themselves becoming losers).
• When the cost-benefit accounts are presented in this way, there
often are items which appear as benefits for one person and
equally-valued costs for someone else: such items are transfer
payments or pecuniary externalities.
CBA – SCB vs. WTP
• For example, consider a straightforward market
transaction: a person buys and consumes a can of beer.
• In the calculation of social costs and benefits, the
marginal cost of producing the beer is a social cost,
while the consumer's enjoyment of the beer is a social
benefit; the actual payment made for the beer ' is a
transfer payment, and is ignored.
• In contrast, the calculus of WTP would record a benefit
to the consumer equal to the consumer's surplus on the
beer, i.e. the excess of WTP over the price paid, and it
would record a benefit to the producer of the beer equal
to the producer's surplus, i.e. the excess of price
received over marginal cost.
CBA: WTP vs. SCB
Willingness to Pay
Q Q
0
Di  P di   P  S i di
0

A B
A

P
Social Cost Benefit
B

Q Q

C  0
Di di   Si di
0

A+B+C C
Q
STAG
• Scottish Transport Appraisal Guidance
– Objective led system of option appraisal
– Appraisal taken against 5 government objectives
• Key themes running through the STAG appraisal
methodology
– Objective led
– Open-minded
– Pragmatic
– Auditable
– Inclusive
Government Objectives
• Environment
• Economy
• Safety
• Integration
• Accessibility and Social Inclusion
Economy
• Analysis of the extent of economic impacts
resulting from a proposal;
• Transport Economic Efficiency (TEE) –
welfare gain which results from an
intervention; and
• Economic Activity and Location Impacts
(EALI) – measures the distributional effect of
the intervention, in terms of employment and
income.
• Wider Economic Impacts (WEBs) –
Agglomeration impacts
TEE Analysis
• Cost-Benefit Analysis under the WTP
framework introduced by the 2003 Green
Book
• Appraisal period is 60 years from scheme
opening
• Values are discounted present values at
2002 market prices.
Forth Replacement Crossing
Example – Forth Replacement
Crossing
FRCS Replacement Crossing Economics (£mill, 2002 values and prices)

C C D D D E
Corridor
Cable-
Immersed Suspension
Crossing Type Tunnel Tunnel Stayed Tunnel
Tunnel Bridge
Bridge

Present Value of Benefits (PVB) 4,655.6 4,655.6 5,303.1 6,026.1 6,026.1 6,317.1

Present Value of Costs (PVC) -2087.4 -1,911.4 -1967.7 -1,397.3 -1,574.9 -2,172.2
Net Present Value (NPV) 2568.2 2,744.2 3,335.3 4,628.8 4,451.1 4,144.9
Benefit to Cost Ratio (BCR)* 2.23 2.44 2.70 4.31 3.83 2.91

The preferred option did actually have the highest BCR (cable stayed bridge).
However, other options (at an earlier stage) and within the work show (e.g. tunnels)
were primarily discounted on environmental grounds.
Example – Edinburgh Tram Line 1

• STAG appraisals originally undertaken


separately for Line 1 and line 2
But economy is only one criteria
Does TEE capture the whole
(economic) story?
The SACTRA (1999) report on Transport and the Economy
considered in some detail the extent to which these
impacts are indeed an acceptable approximation. The
report argued that in a notional perfectly competitive
economy the net transport benefits of a project as
assessed in cost benefit analysis would be identical to
the total economic benefits.

The full Standing Advisory Committee on Trunk Road Assessment (SACTRA) report
can be found at:
http://www.dft.gov.uk/stellent/groups/dft_econappr/documents/page/dft_econappr_02
2512.hcsp
SACTRA conclusions
‘At this stage, the evidence available to us
suggests that a fully-specified and properly
executed cost-benefit analysis, of the kind
traditionally undertaken for transport
projects, will often provide a sufficiently
good approximation for the size of the total
economic impacts…’
Market linkages
Transport market:
Change in Transport Change in Transport
demand supply

Change in Transport
Direct utilisation

E: Changes in B: Changes in A: Changes in vehicle


C: Inward
leisure / D: Location of firms business operating
Investment
Commuting time Travel time costs

J: Commuting K: Migration
response response

O: Change in
P: Increased labour N: Change in M: Competition L: Agglomeration G: Change in labour
housing
Market area land-values effects effects productivity
demand

I: Change in labour H: Labour demand


supply
Q: Change in real
F: Productivity
wages
and employment Change in
Economic
Growth
E: Changes in C: Inward
leisure / D: Location of firms
Investment
Commuting time

K: Migration
response

O: Change in
Capital market
N: Change in
housing
land-values
demand

Labour market
E: Changes in
leisure / B: Changes in
Commuting time business
Travel time

J: Commuting K: Migration
response response

P: Increased labour G: Change in labour


Market area Land market Capital market productivity

I: Change in labour H: Labour demand


supply

Q: Change in real
wages
and employment
C: Inward
D: Location of firms
Investment

M: Competition L: Agglomeration
Land market effects effects

Labour market
Agglomeration
• The methodology is based on the observed correlation between
density of employment and productivity.

• WB1 are the agglomeration benefits of the option (the ‘do-


something’ situation (S)) compared with the do-minimum situation
(M), to be calculated;
• i is a zone for which agglomeration benefits are being calculated - all
of the modelled zones are included in the summation;
• diS, diM are the effective densities of zone i in the do-something
situation S and do-minimum situation M respectively
• diB is the effective density of zone i in the base year (all other
values are for the forecast year), e is the elasticity of productivity
with respect to effective density (Graham, 2005);
• h is GDP per worker in i and EiS is employment (in the do-
something case).
Agglomeration cont.
• Effective density is a measure of the accessibility of zone i to jobs in all
zones. The formula for effective density, of zone i, in situation X (X is base,
Do-minimum or Do-Something) is given by:

• where EjX is the employment in zone j and gijX is the generalised cost of
travelling between zone i and j in situation X, and the parameter α
represents the importance of distance in determining access to markets.
• This notion of generalised cost is given by a weighted average over:
• The weights used in these steps are the numbers of trips (persons or goods
vehicles) by mode and purpose in the base case. These weights are based
on the numbers of trips between the pair of zones considered in each
calculation.
• A detailed transport model, such as Transport Model for Scotland (TMfS),
can be used to produce a value of agglomeration benefits using the
methodology outlined above.
Agglomeration Productivity
Aggregate Response Calculator
• The basic principle of the approach is to define a single zone for the purposes of the
calculation.

• and thus, the terms in g represent the ratio of the generalised cost of travel in the
base year versus the do-something and do-minimum respectively.
• This is useful as it means that the precise form of generalised cost is not important -
what is important is the proportional change of both the do-minimum and do-
something over the baseline.
• This method has the advantage in that the modelling resource requirements are kept
to a minimum - any transport model should, in theory, be able to generate a change
in total generalised cost.
• It is worth noting that gijX as originally defined is a distance based measure - two
zones are clearly a physical distance apart as the crow flies although new
infrastructure may mean the distance that needs to be travelled may change. The
generalised cost measure in the aggregate case is not distance based in the same
way.
BCR under WTP and Public sector
cost
• Under the WTP framework the BCR is sensitive
to Public Sector Cost rather than cost to society.
• As such, the BCR can be influenced by indirect
tax revenues. The NPV of a scheme does not
change (indirect tax is a transfer payment – if the
government gains tax, then the private sector
will lose benefits (by paying the tax)
• A scheme that generates tax revenue will have a
higher BCR than a scheme that doesn’t.
• As such the BCR can be a distorted measure.
BCR and Public sector cost
"Poor" project "Good" project

1 2 3 1 2 3

Capital Costs a -1500 -1500 -1500 -500 -500 -500


User benefits (TOTAL) b 1000 750 1250 1000 750 1250
Private Value Benefits C=b
(TEE) 1000 750 1250 1000 750 1250
Costs to government
Grant/Subsidy payments d -1500 -1500 -1500 -500 -500 -500
Indirect taxation e 0 250 -250 0 250 -250
PVC F=d+e -1500 -1250 -1750 -500 -250 -750
NPV g=(c+f) -500 -500 -500 500 500 500
BCR (Government) =(g+|f|)/ |f| 0.67 0.60 0.71 2.00 3.00 1.66
BCR (Society) =(g+|a|)/|a| 0.67 0.67 0.67 2.00 2.00 2.00
CFA H=d -1500 -1500 -1500 -500 -500 -500
BCR (Funding Agency) =(g+|h|)/|h| 0.67 0.67 0.67 2.00 2.00 2.00

Indirect tax impact 0 250 -250 0 250 -250


Extreme case
Indirect taxation gain equal to (Non-
Tax) Public Sector Cost

5
BCR -Poor
BCR - Good 4

0
-2000 -1500 -1000 -500 0 500 1000 1500 2000
Reduction in indirect taxation -1 Increase in indirect
taxation
-2

-3

-4

-5
BCR solution
• Can use BCR to society measure or Cost
to Funding Agency (which can get around
UK taxation issues in a devolved
administration………).
• It is much harder to deal with developer
contributions. These are treated as a cost
to the private sector and a benefit to
government but for a poor scheme make
the BCR worse…….
"Poor" project "Good" project
Capital Costs -1500 -1500 -500 -500
User benefits (TOTAL) 1000 1000 1000 1000
Developer contribution 0 -250 0 -250

Private Value Benefits (TEE) 1000 750 1000 750


Costs to government
Grant/Subsidy payments -1500 -1500 -500 -500
Developer contribution 0 250 0 250
PVC -1500 -1250 -500 -250
NPV -500 -500 500 500
BCR (Government) 0.67 0.60 2.00 3.00
BCR (Society) 0.67 0.67 2.00 2.00
CFA -1500 -1250 -500 -250
BCR (Funding Agency) 0.67 0.60 2.00 3.00

Developer contribution 0 250 0 250


Environmental Valuation
• CO2 values are now incorporated into analysis.
• Uses the shadow price of carbon dioxide –
around £30 per tonne.
• But other environmental issues much harder to
incorporate.
• Possible for Local Air Quality
• But much harder for less “concrete” factors.
• Not a fundamental issue with CBA but with any
method of monetarisation.
Criticisms of CBA
• http://www.foe.co.uk/resource/reports/policy_appraisal.pdf
• http://www.prospect.org/cs/articles?articleId=7696
– Pricing the priceless
– Troubling trade-offs
– Uncertainty and Precaution
– Distorting the future
– Exaggerated costs
– Partisan + Technicalities
• Alternatives
– Multicriteria approach
– Holistic evaluation – links to Social return on Investment
(http://www.sroi-uk.org/)
– Cost effectiveness
• Alternatives or extensions?
Alternatives to CBA
• Social Return on Investment – Not a strict alternative but a variation
– Involve stakeholders
Understand the way in which the organisation creates change through a dialogue with
stakeholders
– Understand what changes
Acknowledge and articulate all the values, objectives and stakeholders of the organisation
before agreeing which aspects of the organisation are to be included in the scope; and
determine what must be included in the account in order that stakeholders can make
reasonable decisions
– Value the things that matter
Articulate clearly how activities create change and evaluate this through the evidence
gathered
– Only include what is material
Make comparisons of performance and impact using appropriate benchmarks, targets and
external standards.
– Do not over-claim
Demonstrate the basis on which the findings may be considered accurate and honest; and
showing that they will be reported to and discussed with stakeholders
– Be transparent
Ensure appropriate independent verification of the account
– Verify the result
Use financial proxies for indicators in order to include the values of those excluded from
markets in same terms as used in markets
• Perhaps difficult to see the rigour