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

2. Structure What is Cost Benefit Analysis (CBA)? Process Issues in 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
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?