Cost benefit analysis in policy making ta 181113

Using cost-benefit analysis in policy making

18 November 2013

Tera AllasDirector General, Strategic Advice

Department for Business, Innovation and Skills

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Using cost-benefit analysis in policy making: outline of today’s discussion

• Overall policy making process and role of cost-benefit analysis in it

• The objective function(s) and decision making criteria in government policy making

• Using cost-benefit analysis as a framework and quantitative tool to inform policy making and decisions

• Key concepts in cost-benefit analysis without which conclusions are suspect

• Challenges in applying cost-benefit analysis and the role of judgement

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While not linear in reality, the broad policy making process is made up of key stages

Understand the

problem

Scope the policy work

Collect and analyse

evidence

Consultation

Recommend policy to Ministers

Identify, develop and test policy

options

Clearance: Cabinet

Committee, RPC

Delivery – including

legislation if applicable

• What is the problem? • What are the outcomes?• Who are the stakeholders?

• What are government’s levers? • Major overhaul or minor adjustments? • Early engagement of Ministers and Spads

• From Economists and Analysts• From Stakeholders

• Explore innovative solutions - does Govt have to deliver, alternatives to legislation/regulation• Weigh up – vfm, regulatory impact, links with existing policy, etc.• Test strong options with stakeholders• Identify possible ‘unintended consequences’

• Delivery plan - project and risk management• Actions in Departmental Business Plans • Communicating the policy – Comms strategy• Monitoring and Evaluation – testing success of policy in practice

• Ensure Ministers make informed decisions - “no surprises”

Simplified overview of the policy making process

Examples of ways in which economics and analysis add value

• Identifying market failures that may require rectifying

• Horizon scanning and analysis of emerging trends

• Quantifying impact of issues or problems on the economy

• Using tool-kit of potential interventions to identify options

• Connecting with citizens’ and businesses’ behaviour/incentives

• Identifying 2nd order consequences through systems thinking

• Modelling impacts and monetary costs/benefits of options

• Helping understand risk and uncertainty in decision making

• Defining meaningful performance indicators and monitoring them

• Communicating messages compellingly with supporting facts

• Monitoring and evaluating outcomes and reporting on them

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Analytical approaches have a key contribution to make in each stage

Identifyingissues

Prioritisingissues

Developingoptions

Appraisingoptions

Decidingon policy

Implementingoptions

Evaluatingperformance

Mak

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Slightly different frameworks are used to assess different policy instruments

Main appraisal terminology and tools in use in UK government

Policy instrument Appraisal tool

Tax Policy costings* (annex of budget document)

Spend Business cases** (5 case model)

Regulation Impact assessments***

Information Depends on whether delivered through spend or regulation

See for example https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/221895/budget2013_policy_costings.pdf** See for example https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/190601/Green_Book_guidance_public_sector_business_cases_using_the_Five_Case_Model_guidance.pdf*** See for example https://www.gov.uk/producing-impact-assessments-guidance-for-government-departments

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• Key concepts in cost-benefit analysis without which conclusions are suspect


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The basic idea behind cost-benefit analysis is to find a policy “optimum”

Illustrative shape of costs and benefits of any area of spendImaginary monetary units

Optimum is around here

Net benefits can be negative!

Scale or scope or sophistication of activity

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Policy makers are often faced with multiple objective functions to optimise against

Economic efficiency =“maximise economic/social welfare”

Fairness = “maximise equity and minimise

distributional distortions”

Public acceptance =“maximise match with citizens’ preferences”

Objective functions in policy making

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Practical, political, legal and technical reasons lead to multiple decision criteria

Key categories of decision making criteria in policy making

• Economic – e.g., costs and benefits, growth, jobs• Financial – e.g., affordability• Managerial – e.g., deliverability, risk profile• Commercial – e.g., contractual liabilities• Social – e.g., distributional impacts, regional impacts• Environmental – e.g., sustainability, air quality• Legal – e.g., Human Rights, Data Protection, EU law• Other – e.g., information management requirements,

health and safety, consumer focus, design quality

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Cost-benefit analysis is focused on optimising economic welfare

Totaleconomic

welfare

“Pure” economicbenefits

Societalbenefits

Environmentalbenefits

Scientificdiscoveries

Innovations

E.g., text messaging, high-efficiency gas boilers

E.g., penicillin, un-aerobicdigestion

E.g., lower resource costs, consumer/user convenience

E.g., improved care of the elderly, community cohesion

E.g., lower depletion of naturalcapital, lower emissions

EXAMPLE: Economic welfare benefits of science and innovation

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Economic welfare is not exactly the same as GDP or growth – but is related

Very roughly (!) Economic welfare = GDP + consumer surplus +/- externalities

* Nominal growth – where nominal GDP grows because prices of labour, goods and services increase (inflation) – does not increase employment, living standards or the Government’s fiscal position (and therefore ability to offer public services); real growth (which strips out inflation) is the appropriate policy goal

Price levelPrices of labour,goods and services

OutputQuantity of goods and services bought and sold

Aggregatesupply

Aggregatedemand

Consumer surplus

GDP [at prevailing prices, taxes and subsidies]

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International comparisons of GDP per capita and life satisfaction

GDP per capita in 2003, 2000 PPP

The size of the circles corresponds to population size

GDP is often used as an additional metric due to comparability and relevance

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• Key concepts in and elements of cost-benefit analysis without which conclusions are suspect


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As mentioned, economic welfare is one of several considerations in decision making

EXAMPLE: Department for Transport decision framework [1/3]

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Cost-benefit analysis takes into account quantitative and qualitative factors

EXAMPLE: Department for Transport value-for-money framework

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Often it is impossible to conclude much without some element of quantification

EXAMPLE: Possible costs and benefits of new nuclear power relative to a counterfactual of new gas fired power stations

Type Costs Benefits

Economic • Development costs• Transmission costs• Construction costs• Cost of capital• Waste disposal costs• Decommissioning costs• Potential health and safety costs

and/or risks

• Lower fuel costs• Lower operating costs• Longer economic life• Potential benefits from diversity• Potential innovation spill-overs and

export potential• Potentially lower electricity prices

improving competitiveness of industry

Social • Fear of accidents• Fear of terrorism

• Regeneration in potentially deprived communities

• Potential re-skilling of workforce

Environmental • Potential contamination• Potential landscape issues

• Lower CO2 and other emissions• Fuel source sustainability

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For example, time savings are often the biggest element of transport benefits

EXAMPLE: Quantified benefits of roads investment

A421 Improvements: M1 Junction 13 to Bedford.

£0

£200

£400

£600

£800

£1,000

£1,200

£1,400

£1,600

£1,800

Millio

ns

Total Benefits

Time and Money

Savings: Transport Providers

Time and Money

Savings: Consumers

Accident Savings

Carbon Savings

Source: Department for Transport

Mil

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(N

PV

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There are a few fundamental concepts that underpin robust cost-benefit analysis

Key concepts underpinning cost-benefit analysis

• Rationale for intervention• Time value of money• Counterfactual• Additionality• Monetisation (valuation)• Dynamic effects• Optimism bias• Risk• Option value

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Government intervention is justified when markets fail to deliver an optimal outcome

Rationale for government intervention

Type Explanation Key reasons

Economic efficiency

Market failures mean that the market-driven outcome diverges from a socially optimal outcome

Public goods•Non-rival (e.g., clean air) or non-excludable (e.g., defence)•Problems of free-ridingExternalities•Costs or benefits are not priced by market and do not accrue to the agent responsible for generating them•Positive (e.g., R&D) and negative (e.g., pollution) effectsImperfect information•Problems of inefficiency, asymmetry and moral hazardMarket power•Problems of super-normal rents and under-investment

Equity Market-driven outcomes are considered inequitable

Differential impacts on different groups•E.g., city dwellers vs. rural population•Problems of “winners” and “losers”Marginal propensity to consume•Marginal value (utility) of consumption is higher for lower-income individuals

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Appraisal attempts to estimate a monetary value for many non-market goods

“Goods” for which monetary values can be used in appraisal

• Air quality• Noise• Crime• Ambiance• CO2 emissions• Time savings• Health (QUALY)• Life• Regeneration• Reliability

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It is important to consider 2nd order price and other dynamic effects

EXAMPLE: Dynamic effects of improved energy efficiency

Price levelPrice of a unit of “comfort” (e.g., warmth, light, time, convenience)

Quantity of “comfort”Quantity of “comfort” suppliedand demanded at any price level

Original supplyDemand

New supplyImprovements in energy efficiencymay in fact result in higher CO2 emissions

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Optimism bias needs to be factored into cost and benefit calculations

EXAMPLE: Cost estimates for High Speed 2

Date Source Estimate

March 2010 DfT £17bn

June 2013 DfT £42bn

July 2013 Boris Johnson £70bn

August 2013 Institute of Economic Affairs

£80bn

Source: http://en.wikipedia.org/wiki/High_Speed_2

http://en.wikipedia.org/wiki/High_Speed_2

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It is impossible to say in the abstract what type of transport projects are best

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All approved schemes, capital cost vs. BCR

1

2

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4

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0 1 2 3 4 5 6 7Capital cost band

BC

R

Road

Bus and local PT

Rail

Walking and cycling

A

B

£0-20m £20-50m £250-500m£100-250m£50-100m £500m-1bn >£1bn

Benefit-to-cost ratios of different types of transport projects

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Capital cost band

EXAMPLE

C ro s s ra il's E s tim a te d B e n e fits

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A g g lo m e ra t io n

B u s in e s s T im e S a vin g s

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Traditional cost-benefit analysis can leave out important macroeconomic effects

EXAMPLE: Estimates of Crossrail benefits and costs

Source: Crossrail and Department for Transport

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The results are often highly sensitive to uncertain underlying assumptions

EXAMPLE: Estimates of net benefits of new nuclear build over 40 years, £/GW

Source: http://webarchive.nationalarchives.gov.uk/+/http://www.berr.gov.uk/files/file39525.pdf

http://webarchive.nationalarchives.gov.uk/+/http://www.berr.gov.uk/files/file39525.pdf

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The optimal electricity mix depends critically on oil prices which are volatile

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Cost of electricity under different scenarios* (note: illustrative only)£/MWh

Historical oil prices$/bbl in 2012 dollars

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64

87

83

80

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Gas fired

Coal fired

Nuclear

On-shorewind

Low High

EXAMPLE

http://www.economywatch.com/

Economically optimal levels of provision often feel too low to people and politiciansEstimates of acceptable capacity margin (“spare” supply over peak demand) in the UK electricity system% of peak demand

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Generally accepted Based on cost-benefitanalysis

15-20%

8-12%

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EXAMPLE

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People’s preferences tend to differ from “economically perfect rationality”

Known preference patterns (“cognitive shortcuts”) that diverge from “perfect rationality”

Loss aversion Placing much more importance on avoiding losses than securing gains

Availability bias Being overly concerned about unlikely, but memorable or vivid, events

Anchoring Being heavily influenced by your starting point (e.g., sense of entitlement)

Short-termism Preferring small, immediate rewards to larger, more distant ones

Inertia Putting off decisions involving complexity, self-doubt or inconvenience

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In his address to the Top 200 Civil Servants recently, the Prime Minister said:

“I have two priorities at the moment: the economy, and everything else”

Economic growth is currently the government’s number one priority

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Advising government is a privilege and a responsibility requiring careful judgement

One view of success criteria for policy advice in government

Most of the time, data and analysis do not provide a

clear-cut “answer” – but the experts’ best judgement is (very considerably) better than nothing and it is their

responsibility to try to make it relevant, heard and acted

upon, as far as possible

Using cost-benefit analysis in policy making

18 November 2013

Tera AllasDirector General, Strategic Advice

Department for Business, Innovation and Skills

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Cost-benefit analysis typically follows a set of sequential, but iterative, steps

Typical activities in performing cost-benefit analysis

1. Set objectives and decision criteria2. Identify a realistic set of options3. Identify and value the costs of each option4. Identify and value the benefits of each option5. Adjust for distributional impacts and 2nd order impacts

(e.g., relative prices)6. Discount using social time preference rate7. Adjust for material tax differences8. Adjust for risk and optimism9. Consider unvalued costs and benefits

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Meeting the PM’s challenge requires policy makers to understand what drives growth

GDP per capita£ ‘000

Labour participationHours worked

per capita

Labour productivity£ GVA* perhour workedPopulation

m

GDP£ billion

x

x

First-order drivers**include:

• Aggregate demand• Incentives to work• Cost of labour• Labour market

efficiency• Skills• Competition• Trade• Enterprise• Innovation• Investment

* GVA=Gross Value Added; value of outputs (price times quantity) minus value of inputs; when aggregated up across sectors and adjusted for taxes and subsidies, adds up to total GDP [GDP = GVA + taxes on products/services – subsidies on products/services]** Many of the drivers are interconnected (e.g., enterprise drives innovation; trade drives competition) and are themselves driven by other factors (e.g., investment is driven by business environment, including interest rates, taxes, regulataory environment, planning system, etc.)

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Policy makers should also know key economic concepts relevant to their work

Example list of key economic concepts everyone should know

• Marginal costs and benefits• Opportunity cost• Counterfactual• Net present value (NPV)• Market failure• Externalities• Incentives (rational choice)• Supply and demand dynamics• Creative destruction (competition)

Cost benefit analysis in policy making ta 181113

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