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Cost benefit analysis

Author: Geoff Riley  Last updated: Sunday 23 September, 2012

Introduction

In a world of finite public and private resources, we need a standard for evaluating trade-offs, setting priorities, and finally making choices about how to allocate scarce resources among competing uses. Cost benefit analysis provides a way of doing this.

The cost-benefit principle says that you should take an action if, and only if, the extra benefit from taking it is greater than the extra cost

Here are some examples where the principle might be built into your analysis and evaluation

  • Costs and benefits of subsidies e.g. the bio-fuel debate or subsidies
  • Costs and benefits of the introduction of competition e.g. postal market liberalisation
  • Costs and benefits of different strategies designed to reduce income and wealth inequality e.g. the national minimum wage or a rise in the top rate of income tax
  • Costs and benefits of the introduction of carbon trading as a way of reducing CO2 emissions
  • Costs and benefits of major infrastructural projects such as new motorways, London 2012
  • Costs and benefits of a decision to relax planning controls on new house-building

What is cost benefit analysis?

Cost benefit analysis (CBA) is a technique for assessing the monetary social costs and benefits of a capital investment project over a given time period. The principles of cost-benefit analysis (CBA) are simple:

  • Appraisal of a project: It is an economic technique for project appraisal, widely used in business as well as government spending projects (for example should a business invest in a new information system)
  • Incorporates externalities into the equation: It can, if required, include wider social/environmental impacts as well as ‘private’ economic costs and benefits so that externalities are incorporated into the decision process. In this way, CBA can be used to estimate the social welfare effects of an investment
  • Time matters! CBA can take account of the economics of time – known as discounting. This is important when looking at environmental impacts of a project in the years ahead

Uses of CBA

  • CBA has traditionally been applied to big public sector projects such as new motorways, by-passes, dams, tunnels, bridges, flood relief schemes and new power stations.
  • The basic principles of CBA can be applied to many other projects or programmes. For example, - public health programmes (e.g. the mass immunization of children using new drugs), an investment in a new rail safety systems, or opening a new railway line.
  • Cost benefit analysis was also used during an inquiry into genetically modified foods.
  • Increasingly the principles of cost benefit analysis are being used to evaluate the returns from investment in environmental projects such as wind farms and the development of other sources of renewable energy, an area where the UK continues to lag behind.
  • Because financial resources are scarce, CBA allows different projects to be ranked according to those that provide the highest expected net gains in social welfare - this is particularly important given the limitations of government spending.


Main Stages in the Cost Benefit Analysis Approach

At the heart of any investment appraisal decision is this basic question – does a planned project lead to a net increase in social welfare?

Stage 1(a) Calculation of social costs & social benefits. This would include calculation of:

    Tangible Benefits and Costs (i.e. direct costs and benefits)

    Intangible Benefits and Costs (i.e. indirect costs and benefits – externalities)

This process is very important – it involves trying to identify all of the significant costs & benefits

Stage 1(b) - Sensitivity analysis of events occurring – this relates to an important question - If you estimate that a possible benefit (or cost) is £x million, how likely is that outcome? If you are reasonably sure that a benefit or cost will ‘occur’ – what is the scale of uncertainty about the actual values of the costs and benefits?

Stage 2: - Discounting the future value of benefits - costs and benefits accrue over time. Individuals normally prefer to enjoy the benefits now rather than later – so the value of future benefits has to be discounted

Stage 3: - Comparing the costs and benefits to determine the net social rate of return

Stage 4: - Comparing net rate of return from different projects – the government may have limited funds at its disposal and therefore faces a choice about which projects should be given the go-ahead

Evaluation: Criticisms of COBA

There are several objections to the use of CBA for environmental impact assessment:

  • Problems in attaching valuations to costs and benefits: Some costs are easy to value such as the running costs (e.g. staff costs) + capital costs (new equipment). Other costs are more difficult – not least when a project has a significant impact on the environment. The value attached to the destruction of a habitat is to some “priceless” and to others “worthless”. Costs are also subject to change over time – I.e. the construction costs of a new bridge over a river or the introduction of electronic road pricing
  • The CBA may not cover everyone affected (i.e. all third parties) – inevitably with major construction projects such as a new airport or a new road, there are a huge number of potential “stakeholders” who stand to be affected (positively or negatively) by the decision. COBA cannot hope to include all stakeholders – there is a risk that some groups might be left out of the decision process
    1. Future generations – are they included in the analysis?
    2. What of “non-human” stakeholders?
  • Distributional consequences: Costs and benefits mean different things to different income groups - benefits to the poor are usually worth more (or are they?). Those receiving benefits and those burdened with the costs of a project may not be the same. Are the losers to be compensated? To many economists, the equity issue is as important as the efficiency argument.
  • Social welfare is not the same as individual welfare - What we want individually may not be what we want collectively. Do we attach a different value to those who feel “passionately” about something (for example the building of new housing on Greenfield sites) contrasted with those who are more ambivalent?
  • Valuing the environment: How are we to place a value on public goods such as the environment where there is no market established for the valuation of “property rights” over environmental resources? How does one value “nuisance” and “aesthetic values”?
  • Valuing human life: Some measurements of benefits require the valuation of human life – many people are intrinsically opposed to any attempt to do this. This objection can be partly overcome if we focus instead on the probability of a project “reducing the risk of death” – and there are insurance markets in existence which tell us something about how much people value their health and life when they take out insurance policies.
  • Attitudes to risk – e.g. a cost benefit analysis of the effects of genetically modified foods
    1. Precautionary Principle: Assume toxicity until proven safe
      • If in doubt, then regulate
    1. Free Market Principle: Assume it is safe until a hazard is identified
      • If in doubt, do not regulate.
  1. Weighing qualitative factors such as social inclusion effects, policy integration/cohesion, accessibility/discrimination and the “legacy effects” of capital investment

Despite these problems, most economists argue that CBA is better than other ways of including the environment in project appraisal.

Discounting the future

Would you rather have £1000 of income today or £1000 of income in the future (say in 3 years?). The answer is probably now, because £1000 in three years time is unlikely to buy as many goods and services as it does now (because of inflation). And also because £1000 put into a savings account today will yield interest.

Discounting is a widely used technique as part of cost benefit analysis. The technique of discounting reflects the following:


The value of a cost or benefit now > the value of a cost or benefit in future years

Discounting reflects this by reducing all future costs and benefits to express them as today’s values. The key question is: How do you choose an ‘interest rate’ for reducing future costs to give them a present value today?

Setting a general discount rate for new projects has important implications for the environment:

  • A low discount rate is often favoured by economists since they argue that investing a high proportion of current income is a good way of providing for the future
  • A high discount rate may also be favoured since it discourages investment (and by implication environmental damage) in the present

Most projects have lifetimes of 20-30 years – with many of the big costs arising early in a project e.g. from construction whereas the stream of benefits from a project occur over a much longer period of time. But for many huge construction projects, some of the costs only become apparent in the long run. Consider the building of a new nuclear power station. Environmentalists would argue that there is a long list of costs from waste management and decommissioning which stretch over 100 years into the future whereas no social benefits exist to offset these costs beyond year 30 or 40 (where the nuclear power station might reasonably be expected to be ready for closure).

The value of decommissioning costs over 100 years away is almost negligible no matter what discount rate we use. This makes discounting difficult to justify

Infrastructure spending and Cost Benefit Analysis

A number of major infrastructural projects are planned in the UK over the coming years. Each of them could be considered using some of the principles of cost-benefit analysis. Examples include:

  1. Nuclear power plants: Expansion or renovation planned at more than a dozen nuclear facilities, raising concerns about safety and waste disposal.
  2. Reservoirs: To combat long term water supply shortages the government is planning to expand six reservoirs in the South and South-east
  3. Incinerators: New EU environmental regulations could lead to the building of three massive centralised disposal units for millions of tonnes of commercial and household waste.
  4. Airports and extra runways: With an extra 100m passengers predicted to be using UK airports by 2030, there are new runways planned for four airports as part of a huge expansion programme.
  5. The Severn Barrage: Harnessing tidal power could generate up to 5 per cent of Britain's electricity needs from the Severn Barrage alone.
  6. Gas pipelines: Six huge underground gas fields built after surge in imports of liquefied petroleum gas and collapse in North Sea supply.
  7. New roads: About 500 miles of extra roads are planned together with a series of road widening schemes

To recap, cost benefit analysis is basically an appraisal technique that tries to place monetary values on all benefits arising from a project and then compares the total value with the project's total cost. It has numerous potential applications although there are inherent difficulties with the issue of valuation.

Essentially the process of COBA is a comparative one, so that we can perhaps make judgements about which projects from a limited choice should be given the go ahead.





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