Clean Copy - Cost Benefit Analysis Module

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Productivity Commission

Capacity Building On Regulatory Review

Impact Analysis Module

Applying cost benefit analysisto regulatory proposals

21-25 March 2011

Rod Bogaards


Australian Government


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Productivity Commission 2

Some things just dont add up!


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A sobering thought

There are significant challenges in using CBA

Mainly because it is inherently difficult to accurately

measure benefits and costs in dollar terms

But even when it is difficult to measure benefits andcosts with any precision, applying the CBA framework isimportant and useful


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Questions to be addressed

What is Cost Benefit Analysis (CBA)?

When did Australian Governments develop a heightenedinterest in CBA?

Why is CBA useful?

Where does CBA fit into the RIS/RIA process?

When should you conduct CBA?

What are the basic steps in conducting CBA?

What services could be provided by a CBA Unit?


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What is Cost Benefit Analysis?

CBA is an analytical tool used to assess the benefitsand costs of regulatory proposals

Given sufficient information, CBA can:

calculate the net benefits for each proposal

rank proposals by their net benefits

recommend the proposal with the greatest netbenefit


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When did Australian Governments develop a

heightened interest in CBA?

Government decisions of 2005/2006 gave renewedfocus to CBA

Implications:

government agencies need to build their capacityto use CBA to improve the quality of regulatory

impact analysis

greater use of CBA expected by governments forregulatory proposals


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Why is CBA useful?

CBA examines costs and benefits from theperspective of the community as a whole:

it forces a wider view on decision makers

promotes comparability and encourages consistentdecision making

its aim is to maximise community net benefits

CBA includes all costs and benefits it tells the wholestory



Why is CBA useful?

CBA provides a summary of the efficiency effects of apolicy

But CBA can draw attention to equity issues

by identifying who gains and who loses from aregulatory proposal

but it is up to decision makers to decide whetherdistributional impacts/equity issues are importantand need addressing



Where does CBA fit into the RIS/RIA process?

1. Problem

2. Objectives

3. Options

4. Impact analysis

5. Consultation

6. Conclusion and recommended option

7. Implementation and review



When do you need to conduct CBA?

Should be a greater focus on valuing impacts indollars for regulatory proposals, particularly thosewith significant impacts

But non-monetised costs and benefits should notbe excluded from consideration in CBA

Impacts should be reported in CBA as follows: monetised

quantified, but not monetised

qualitative, but not quantified or monetised


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Existence of non-monetised costs and benefits

presents a challenge

Agencies should consider non-monetised impactsadequately but not overplay them

If a proposal shows large monetised net coststhe onus is on the government agency to clearlyexplain why non-monetised benefits would tip thebalance


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What are the basic steps in conducting a CBA?

1. Specify the set of policy options

2. Decide whose costs and benefits count

3. Catalogue the impacts and select measurementindicators

4. Predict the impacts over the life of theregulatory proposal


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What are the basic steps in conducting a CBA?

5. Monetise (attach dollar values to) impacts

6. Discount future costs and benefits to obtain

present values

7. Compute the net present value for each policyoption

8. Perform sensitivity analysis

9. Rank the policy options


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1. Specify the set of policy options

Specify the set of policy options to solve aproblem

One of the options should always be maintaincurrent arrangements

The number of potential options can be large

Analysts typically analyse only a few feasibleoptions (usually < 6)


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2. Decide whose costs and benefits count

Usually only take account of costs and benefits atthe national level from the Malaysiancommunitys perspective

Some argue costs and benefits to non-nationalsshould also be included for international/globalissues

However, for most regulatory proposals,measuring national costs and benefits isappropriate


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3. Catalogue the impacts and select

measurement indicators

Identify the full range of impacts of the regulatory proposal

Identify incremental costs and benefits relative to the basecase (i.e. maintain current arrangements)

Changes that would have occurred anyway should not beattributed to the regulatory proposal

Choice of measurement indicator depends on dataavailability and ease of monetisation


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4. Predict the impacts over the life of the

regulatory proposal

Impacts should be quantified for each time periodover the life of the regulatory proposal

Prediction of future impacts is difficult there willalways be some uncertainty surrounding theoutcome of a regulatory proposal

Forecasts of costs and benefits require someassumptions to be made these should be

justified and made transparent


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5. Attach dollar values to all impacts

We measure costs and benefits in dollar terms to enablecomparisons to be made

Analysts must estimate impacts in a variety of

circumstances: competitive markets

distorted markets (e.g. externalities)

no market signals (e.g. human life)

Problems arise where markets do not work well or do notexist - in these cases techniques are available to estimateimpacts

revealed preference techniques

stated preference techniques


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6. Discount future benefits and costs to obtain

present values

Costs and benefits of regulatory proposals are spread outover time

Positive market interest rates indicate that people value adollar in the future less than a dollar now

To reflect this, future benefits and costs are discounted topresent values which expresses them as an equivalentamount in todays dollars

The OBPRs preferred approach is to base the discount rateon market-determined interest rates and suggests using areal discount rate of 7%


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7. Compute the net present value of each

alternative policy option

Net Present Value (NPV) is equal to present valueof benefits minus present value of costs:

NPV = PV(B) PV(C)

If all costs and benefits cannot be valued indollars, outline why non-monetised impacts arelarge or small relative to monetised impacts


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8. Perform sensitivity analysis

There is usually considerable uncertainty aboutpredicted costs and benefits

Sensitivity analysis shows how these uncertainties affect

the CBA results

Three types of sensitivity analysis:

worst/best case analysis

partial sensitivity analysis Monte Carlo sensitivity analysis

If the sign of the net benefits does not change afterconsidering the range of scenarios, there can beconfidence in the CBA results


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9. Rank the policy options

The analyst should specify which option is themost efficient

Generally, it will be the one with the largestNPV

The recommendation should be clearlypresented


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CBA accuracy

The usefulness of CBA depends on its accuracy

Accuracy depends on how well the analyst performs the

nine steps

Each step is subject to errors but most important errorsoccur in steps 3, 4 & 5 relating to:

specifying the cost and benefit categories

predicting the costs and benefits

valuing the costs and benefits in dollars


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Common CBA pitfalls

Downplaying or ignoring non-financial social benefitsand costs

Double counting benefits

Before/after rather than with/without

Selecting a discount rate to deliver a particular result

Ignoring uncertainty no sensitivity analysis


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Without regulation

Regulation

introduced

With regulation

Consider the counterfactual with and

without

Net benefits

Time

f


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Determining impact valuations from secondary

sources

Obtaining valuations is time consuming andresource intensive

Least-cost approach is to use previouslyestimated valuations dont have to reinvent thewheel

Refer to such estimates as plug-ins or benefits

transfer or information transfer

Although catalogues of impact values are notcomprehensive, considerable progress has beenmade


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Frequently used plug-ins include:

Value of a statistical life or life year

Value of travel time savings

Value of recreational activities

Value of nature (species or habitats)

Cost of noise pollution

Cost of air pollution


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Valuing mortality risk reduction or the value of

a statistical life (VSL)

How much would individuals pay to achieve asmall reduction in the probability of death?

Revealed preference and stated preferencestudies can provide estimates of willingness topay for small changes in mortality risk


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VSL is not the value of an identified life!

VSL is the aggregate amount that a group of individuals areWTP for a risk reduction

If people are WTP, on average, $12 for a risk reduction from5 in 500,000 to 4 in 500,000

VSL = $12/0.000002 = $6 million

It does not mean that an individual would pay $6m to avoid(certain) death this year

It does imply that 500,000 similar people would togetherpay $6m to eliminate the risk that is expected to kill one ofthem randomly this year

N t f l f tt hi d ll l t


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No set formula for attaching dollar values to

impacts

High quality analysis may require professionalexpertise consultants can be useful

Different impacts may call for different estimationtechniques

Will depend on the nature and complexity of issueand availability of information


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CBA should be undertaken for all

significant regulatory proposals

Definition of significant requires somejudgement

Scale of CBA should be commensurate withmagnitude of problem

Agencies should devote more resources toproblems where stakes are greater

P i l ith t f


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Preparing proposals with a greater focus on

quantification: key challenges

Proper resourcing

Getting the right skills

Collecting high quality information

Consulting with stakeholders


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What services could be provided by a CBA Unit?

Providing assistance on technical issues

Advising how to improve CBA done in-house or

undertaken by a consultant

Training/Workshops on CBA

Developing CBA guidance material on a needsbasis

Repository of CBA reports


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And remember

Even though many RIA systems require CBA theproportion of RIA that actually manage to fullyquantify costs and benefits, and produce a robust

NPV result, remains relatively small

But dont despair, even if some costs and benefitsremain unquantified, applying the CBA frameworkprovides a very good discipline when examining

regulatory proposals


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Useful CBA References

Office of Best Practice Regulation 2010, Best PracticeRegulation Handbook (Appendix E), June.

Commonwealth of Australia 2006, Handbook of Cost

Benefit Analysis, January.

Boardman, E.A., Greenberg, D.H., Vining, A.R. andWeimer, D.L. 2006 Cost-Benefit Analysis: Concepts andPractice, 3rd edition.

OECD 2006, Cost-Benefit Analysis and the Environment:Recent Developments


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Key messages

CBA is a pragmatic tool for drawing attentionto the likely impacts of regulation

Quantifying costs and benefits is challengingbut not impossible (given sufficient time, skilland resources)

CBA can play an important role in improvingthe quality of regulatory proposals evenwhen valuation is difficult

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Clean Copy - Cost Benefit Analysis Module