Capacity Building On Regulatory Review

Impact Analysis Module

Applying cost benefit analysis

to regulatory proposals 21-25 March 2011
Rod Bogaards Productivity Commission Australian Government

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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 and costs with any precision, applying the CBA framework is important and useful

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Questions to be addressed

What is Cost Benefit Analysis (CBA)?

When did Australian Governments develop a heightened interest 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 benefits and 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 net benefit

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When did Australian Governments develop a heightened interest in CBA?

Government decisions of 2005/2006 gave renewed focus to CBA

Implications: government agencies need to build their capacity to use CBA to improve the quality of regulatory impact analysis greater use of CBA expected by governments for regulatory proposals
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Why is CBA useful?

CBA examines costs and benefits from the perspective of the community as a whole:
it forces a wider view on decision makers promotes comparability and encourages consistent decision making its aim is to maximise community net benefits CBA includes all costs and benefits it tells the whole story
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Why is CBA useful?

CBA provides a summary of the efficiency effects of a policy

But CBA can draw attention to equity issues by identifying who gains and who loses from a regulatory proposal but it is up to decision makers to decide whether distributional impacts/equity issues are important and need addressing

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Where does CBA fit into the RIS/RIA process?

1.

Problem

2.
3. 4. 5. 6. 7.

Objectives
Options Impact analysis Consultation Conclusion and recommended option Implementation and review
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When do you need to conduct CBA?

Should be a greater focus on valuing impacts in dollars for regulatory proposals, particularly those with significant impacts

But non-monetised costs and benefits should not be 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 impacts adequately but not overplay them If a proposal shows large monetised net costs the onus is on the government agency to clearly explain why non-monetised benefits would tip the balance

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What are the basic steps in conducting a CBA?

1. 2. 3.

Specify the set of policy options Decide whose costs and benefits count Catalogue the impacts and select measurement indicators Predict the impacts over the life of the regulatory proposal
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4.

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What are the basic steps in conducting a CBA?

5. 6.

Monetise (attach dollar values to) impacts Discount future costs and benefits to obtain present values Compute the net present value for each policy option Perform sensitivity analysis Rank the policy options
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7.

8. 9.

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1. Specify the set of policy options

Specify the set of policy options to solve a problem One of the options should always be maintain current arrangements The number of potential options can be large Analysts typically analyse only a few feasible options (usually < 6)
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2. Decide whose costs and benefits count

Usually only take account of costs and benefits at the national level from the Malaysian communitys perspective Some argue costs and benefits to non-nationals should also be included for international/global issues However, for most regulatory proposals, measuring national costs and benefits is appropriate
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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 base case (i.e. maintain current arrangements) Changes that would have occurred anyway should not be attributed to the regulatory proposal Choice of measurement indicator depends on data availability 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 period over the life of the regulatory proposal
Prediction of future impacts is difficult there will always be some uncertainty surrounding the outcome of a regulatory proposal Forecasts of costs and benefits require some assumptions 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 enable comparisons 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 not exist - in these cases techniques are available to estimate impacts 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 out over time Positive market interest rates indicate that people value a dollar in the future less than a dollar now

To reflect this, future benefits and costs are discounted to present values which expresses them as an equivalent amount in todays dollars
The OBPRs preferred approach is to base the discount rate on market-determined interest rates and suggests using a real 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 value of benefits minus present value of costs:
NPV = PV(B) PV(C) If all costs and benefits cannot be valued in dollars, outline why non-monetised impacts are large or small relative to monetised impacts

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8. Perform sensitivity analysis

There is usually considerable uncertainty about predicted 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 after considering the range of scenarios, there can be confidence in the CBA results
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9. Rank the policy options

The analyst should specify which option is the most efficient

Generally, it will be the one with the largest NPV The recommendation should be clearly presented

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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 errors occur 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 benefits and 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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Consider the counterfactual with and without

Net benefits

With regulation

Without regulation Time

Regulation introduced

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Determining impact valuations from secondary sources

Obtaining valuations is time consuming and resource intensive

Least-cost approach is to use previously estimated valuations dont have to reinvent the wheel
Refer to such estimates as plug-ins or benefits transfer or information transfer Although catalogues of impact values are not comprehensive, considerable progress has been made
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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 a small reduction in the probability of death? Revealed preference and stated preference studies can provide estimates of willingness to pay 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 are WTP for a risk reduction

If people are WTP, on average, $12 for a risk reduction from 5 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 together pay $6m to eliminate the risk that is expected to kill one of them randomly this year
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No set formula for attaching dollar values to impacts

High quality analysis may require professional expertise consultants can be useful Different impacts may call for different estimation techniques Will depend on the nature and complexity of issue and availability of information

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CBA should be undertaken for all significant regulatory proposals

Definition of significant requires some judgement

Scale of CBA should be commensurate with magnitude of problem Agencies should devote more resources to problems where stakes are greater

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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 needs basis

Repository of CBA reports

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And remember

Even though many RIA systems require CBA the proportion of RIA that actually manage to fully quantify costs and benefits, and produce a robust NPV result, remains relatively small
But dont despair, even if some costs and benefits remain unquantified, applying the CBA framework provides a very good discipline when examining regulatory proposals

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Useful CBA References

Office of Best Practice Regulation 2010, Best Practice Regulation Handbook (Appendix E), June.
Commonwealth of Australia 2006, Handbook of Cost Benefit Analysis, January. Boardman, E.A., Greenberg, D.H., Vining, A.R. and Weimer, D.L. 2006 Cost-Benefit Analysis: Concepts and Practice, 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 attention to the likely impacts of regulation
Quantifying costs and benefits is challenging but not impossible (given sufficient time, skill and resources) CBA can play an important role in improving the quality of regulatory proposals even when valuation is difficult

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