Cost benefit analysis in policy making ta 181113

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Overview of context, purpose and practice of cost-benefit analysis in government

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  • But economic growth is not just about closing the structural deficit and being able to finance public sector expenditure going forward.
    Economic growth also underpins citizens’ well-being and quality of life. International studies demonstrate that – on average – countries with higher levels of prosperity also display higher levels of life satisfaction.
  • Cost benefit analysis in policy making ta 181113

    1. 1. Using cost-benefit analysis in policy making 18 November 2013 Tera Allas Director General, Strategic Advice Department for Business, Innovation and Skills
    2. 2. 2 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
    3. 3. 3 While not linear in reality, the broad policy making process is made up of key stages Simplified overview of the policy making process Consultation Understand the problem Scope the policy work Collect and analyse evidence Recommend policy to Ministers Clearance: Cabinet Committee, RPC Delivery – including legislation if applicable Identify, develop and test policy options • 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’ • Ensure Ministers make informed decisions - “no surprises” • 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
    4. 4. 4 Making a difference to outcomes Analytical approaches have a key contribution to make in each stage Identifying issues Examples of ways in which economics and analysis add value Prioritising issues • Horizon scanning and analysis of emerging trends Developing options • Using tool-kit of potential interventions to identify options Appraising options Deciding on policy Implementing options Evaluating performance • Identifying market failures that may require rectifying • Quantifying impact of issues or problems on the economy • 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
    5. 5. 5 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
    6. 6. 6 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
    7. 7. The basic idea behind cost-benefit analysis is to find a policy “optimum” Gross costs and benefits Illustrative shape of costs and benefits of any area of spend Imaginary monetary units Optimum is around here Net benefits can be negative! Scale or scope or sophistication of activity 7
    8. 8. 8 Policy makers are often faced with multiple objective functions to optimise against Objective functions in policy making Economic efficiency = “maximise economic/social welfare” Public acceptance = “maximise match with citizens’ preferences” Fairness = “maximise equity and minimise distributional distortions”
    9. 9. 9 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
    10. 10. 10 Cost-benefit analysis is focused on optimising economic welfare EXAMPLE: Economic welfare benefits of science and innovation “Pure” economic benefits Scientific discoveries E.g., penicillin, un-aerobic digestion Innovations E.g., text messaging, high-efficiency gas boilers E.g., lower resource costs, consumer/user convenience Societal benefits E.g., improved care of the elderly, community cohesion Environmental benefits E.g., lower depletion of natural capital, lower emissions Total economic welfare
    11. 11. 11 Economic welfare is not exactly the same as GDP or growth – but is related Very roughly (!) Economic welfare = GDP + consumer surplus +/- externalities Price level Aggregate demand Prices of labour, goods and services Aggregate supply Consumer surplus GDP [at prevailing prices, taxes and subsidies] Output Quantity of goods and services bought and sold * 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
    12. 12. International comparisons of GDP per capita and life satisfaction Mean life satisfaction Source: The Hidden Wealth of Nations, David Halpern (Gallup data; graph from Angus Deaton, Harvard) GDP is often used as an additional metric due to comparability and relevance The size of the circles corresponds to population size GDP per capita in 2003, 2000 PPP
    13. 13. 13 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 and elements of cost-benefit analysis without which conclusions are suspect • Challenges in applying cost-benefit analysis and the role of judgement
    14. 14. 14 As mentioned, economic welfare is one of several considerations in decision making EXAMPLE: Department for Transport decision framework [1/3]
    15. 15. 15 As mentioned, economic welfare is one of several considerations in decision making EXAMPLE: Department for Transport decision framework [2/3]
    16. 16. 16 As mentioned, economic welfare is one of several considerations in decision making EXAMPLE: Department for Transport decision framework [3/3]
    17. 17. 17 Cost-benefit analysis takes into account quantitative and qualitative factors EXAMPLE: Department for Transport value-for-money framework
    18. 18. 18 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 • • • • • • • Fear of accidents Fear of terrorism • Social • 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 • Environmental • • Potential contamination Potential landscape issues Regeneration in potentially deprived communities Potential re-skilling of workforce • • Lower CO2 and other emissions Fuel source sustainability
    19. 19. 19 For example, time savings are often the biggest element of transport benefits EXAMPLE: Quantified benefits of roads investment £1,800 £1,600 Time and Money Savings: Transport Providers £1,400 Millions Millions (NPV) £1,200 £1,000 £800 Time and Money Savings: Consumers £600 £400 £200 £0 Carbon Savings Accident Savings A421 Improvements: M1 Junction 13 to Bedford. Source: Department for Transport Total Benefits
    20. 20. 20 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 and elements of cost-benefit analysis without which conclusions are suspect • Challenges in applying cost-benefit analysis and the role of judgement
    21. 21. 21 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
    22. 22. 22 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-riding Externalities •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) effects Imperfect information •Problems of inefficiency, asymmetry and moral hazard Market 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
    23. 23. 23 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
    24. 24. 24 It is important to consider 2nd order price and other dynamic effects EXAMPLE: Dynamic effects of improved energy efficiency Price level Price of a unit of “comfort” (e.g., warmth, light, time, convenience) Demand Original supply New supply Quantity of “comfort” Quantity of “comfort” supplied and demanded at any price level Improvements in energy efficiency may in fact result in higher CO2 emissions
    25. 25. 25 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
    26. 26. 26 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 and elements of cost-benefit analysis without which conclusions are suspect • Challenges in applying cost-benefit analysis and the role of judgement
    27. 27. It is impossible to say in the abstract what type of transport projects are best Benefit-to-cost ratios of different typesvs. BCR All approved schemes, capital cost of transport projects 10 BCR Benefit-cost-ratio (BCR) Source: DfT VfM database 2010 Road EXAMPLE Bus and local PT 9 Rail B Walking and cycling 8 7 6 A 5 4 3 2 1 0 £0-20m 1 £20-50m 2 £50-100m 3 £100-250m 4 Capital cost band Capital cost band £250-500m 5 £500m-1bn 6 >£1bn 7 27
    28. 28. 28 Traditional cost-benefit analysis can leave out important macroeconomic effects EXAMPLE: Estimates of Crossrail benefits and costs Crossrail's Estimated Benefits 40 Costs 35 Move to more productive jobs 30 £bn 25 Labour force participation 20 Imperfect Competition 15 10 Agglomeration 5 Business Time Savings 0 GDP Source: Crossrail and Department for Transport Cost
    29. 29. 29 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
    30. 30. Source: DECC analysis 2008; http://www.economywatch.com/ * Most of the difference for coal and gas fired power comes from changes in fossil fuel prices, which in turn are highly correlated with oil prices The optimal electricity mix depends critically on oil prices which are volatile Cost of electricity under different scenarios* (note: illustrative only) £/MWh On-shore wind Nuclear Coal fired Gas fired 64 82 80 38 Historical oil prices $/bbl in 2012 dollars 83 40 87 37 Low EXAMPLE High 30
    31. 31. Economically optimal levels of provision often feel too low to people and politicians Estimates of acceptable capacity margin (“spare” supply over peak demand) in the UK electricity system EXAMPLE % of peak demand 25 20 15-20% 15 8-12% Source: DECC analysis 2007 10 5 0 Generally accepted Based on cost-benefit analysis
    32. 32. 32 Source: Adapted from MINDSPACE: Influencing behaviour through public policy, Cabinet Office and Institute for Government 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
    33. 33. 33 Economic growth is currently the government’s number one priority 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”
    34. 34. 34 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
    35. 35. Using cost-benefit analysis in policy making 18 November 2013 Tera Allas Director General, Strategic Advice Department for Business, Innovation and Skills
    36. 36. 36 Cost-benefit analysis typically follows a set of sequential, but iterative, steps Typical activities in performing cost-benefit analysis 1. 2. 3. 4. 5. 6. 7. 8. 9. Set objectives and decision criteria Identify a realistic set of options Identify and value the costs of each option Identify and value the benefits of each option Adjust for distributional impacts and 2nd order impacts (e.g., relative prices) Discount using social time preference rate Adjust for material tax differences Adjust for risk and optimism Consider unvalued costs and benefits
    37. 37. 37 Meeting the PM’s challenge requires policy makers to understand what drives growth Labour participation Hours worked per capita GDP per capita £ ‘000 GDP £ billion x Population m x Labour productivity £ GVA* per hour worked 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.)
    38. 38. 38 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)

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