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Incorporating Risk and Uncertainty in Cost-Benefit Analysis

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  • Salci, Sener
  • Jenkins, Glenn

Abstract

Cost-Benefit Analysis (CBA) is a tool for assessing the welfare effects of changes in regulatory and investment interventions. While in many ways an effective approach, a significant drawback of CBA, however, is that it relies on estimates for variables that cannot be predicted with complete accuracy. As such, expected outcomes generated by CBA, such as financial and economic net present values (NPVs), incorporate a degree of risk and uncertainty. It is therefore critical that CBA is based on transparent assumptions about the nature of risk and uncertainty affecting key variables: CBA cannot contribute to rational decision-making unless the distribution of outcomes is clear, and the effect on forecast reliability understood. Real-world risk and uncertainty generate numerous ex-ante outcomes at the point of appraisal. Correctly assessing risk and uncertainty is therefore one of the most difficult challenges decision-makers face in applying the results of CBA. This report offers a systematic approach to the incorporation of risk and uncertainty in CBA. The primary objectives are to review the professional literature on risk and uncertainty; to provide a methodology for taking account of risk and uncertainty in CBA; and to suggest guidelines for the interpretation and application of CBA results in the decision-making process. The treatment of risk and uncertainty are clearly addressed in the CBA guidelines of most OECD countries, although approaches vary. The simplest procedures are based on sensitivity analysis, as applied to a deterministic base case. More comprehensive analysis is based on assumed probability distributions for the variables concerned. The CBA guidelines of multilateral financial institutions and a number of advanced economies (Australia, Canada, France, the UK, the US and the European Union) call for sensitivity analysis on a project-by-project basis, identifying specific long-term risks and uncertainties associated with the assumptions and values used in appraisal and evaluation. Still greater insight into the impact of risk and uncertainty on expected regulatory outcomes can be gained from a probabilistic modeling of variable distributions and their inter-dependencies. A Monte Carlo simulation is therefore recommended alongside sensitivity analysis, where data, time and budget permit.

Suggested Citation

  • Salci, Sener & Jenkins, Glenn, 2016. "Incorporating Risk and Uncertainty in Cost-Benefit Analysis," MPRA Paper 74161, University Library of Munich, Germany.
  • Handle: RePEc:pra:mprapa:74161
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    References listed on IDEAS

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    1. Savvides, Savvakis C., 1994. "Risk Analysis in Investment Appraisal," MPRA Paper 10035, University Library of Munich, Germany, revised 14 Aug 2008.
    2. Laurie Johnson & Chris Hope, 2012. "The social cost of carbon in U.S. regulatory impact analyses: an introduction and critique," Journal of Environmental Studies and Sciences, Springer;Association of Environmental Studies and Sciences, vol. 2(3), pages 205-221, September.
    3. Severin Borenstein & A. Colin Cameron & Richard Gilbert, 1997. "Do Gasoline Prices Respond Asymmetrically to Crude Oil Price Changes?," The Quarterly Journal of Economics, Oxford University Press, vol. 112(1), pages 305-339.
    4. Harry Clarke, 2014. "Evaluating Infrastructure Projects under Risk and Uncertainty: A Checklist of Issues," Australian Economic Review, The University of Melbourne, Melbourne Institute of Applied Economic and Social Research, vol. 47(1), pages 147-156, March.
    5. Tareen, Irfan Y. & Wetzstein, Michael E. & Duffield, James A., 2000. "Biodiesel As A Substitute For Petroleum Diesel In A Stochastic Environment," Journal of Agricultural and Applied Economics, Southern Agricultural Economics Association, vol. 32(2), pages 1-9, August.
    6. Jenkins, Glenn P, 1997. "Project Analysis and the World Bank," American Economic Review, American Economic Association, vol. 87(2), pages 38-42, May.
    7. Tareen, Irfan Y. & Wetzstein, Michael E. & Duffield, James A., 2000. "Biodiesel as a Substitute for Petroleum Diesel in a Stochastic Environment," Journal of Agricultural and Applied Economics, Cambridge University Press, vol. 32(02), pages 373-381, August.
    8. Asche, Frank & Gjolberg, Ole & Volker, Teresa, 2003. "Price relationships in the petroleum market: an analysis of crude oil and refined product prices," Energy Economics, Elsevier, vol. 25(3), pages 289-301, May.
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    Cited by:

    1. Salci, Sener, 2017. "An Integrated Appraisal of the Péligre Electricity Transmission Line Rehabilitation Investment," MPRA Paper 78929, University Library of Munich, Germany.
    2. repec:eee:agisys:v:167:y:2018:i:c:p:161-175 is not listed on IDEAS

    More about this item

    Keywords

    risk analysis; cost-benefit analysis; energy; nonrenewable resources; environment; Canada;

    JEL classification:

    • D61 - Microeconomics - - Welfare Economics - - - Allocative Efficiency; Cost-Benefit Analysis
    • D8 - Microeconomics - - Information, Knowledge, and Uncertainty
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • N5 - Economic History - - Agriculture, Natural Resources, Environment and Extractive Industries
    • N52 - Economic History - - Agriculture, Natural Resources, Environment and Extractive Industries - - - U.S.; Canada: 1913-
    • O13 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Agriculture; Natural Resources; Environment; Other Primary Products
    • Q51 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Environmental Economics - - - Valuation of Environmental Effects
    • Q53 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Environmental Economics - - - Air Pollution; Water Pollution; Noise; Hazardous Waste; Solid Waste; Recycling
    • Q58 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Environmental Economics - - - Environmental Economics: Government Policy

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