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Cost Benefit Analysis

Cost Benefit Analysis. EWG Study Tour, Galway, 18/09/2006. 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. Structure (continued).

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Cost Benefit Analysis

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  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?

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