Thanks, Gene (Adept Economics) for hosting me on an episode of your podcast series Economics Explained. It was great we were able to unpack a few things about city infrastructure for your listeners, particularly regarding Brisbane’s Green Bridges program and Cross River Rail.
Today marks the sixth anniversary of Lytton Advisory as an independent economic consulting practice. Over that time, we have worked on a wide range of economic issues. This has taken us to places as diverse as the Solomon Islands, Papua New Guinea, Kuwait and Saudi Arabia.
We have never lost our enthusiasm for helping clients make smarter capital investment decisions. Neither have we wavered in our passion for proper planning, prioritisation and funding of infrastructure. In more recent years, our work has been around leading project teams of committed, experienced economists and professionals to bring high conviction analyses to our clients. Good cost benefit analysis is at the heart of what we do.
In the first half 2019 founder, Craig Lawrence took, in effect, a sabbatical from the practice to lead the establishment of the Economic and Social Infrastructure Program in PNG. This $130 million 4+4 year Cardno-delivered, Australian Government funded program seeks to improve the quality of planning, prioritisation and funding of infrastructure to achieve economic outcomes and social development goals for Papua New Guineans.
Whether it is: developing an investment manual to incorporate climate change adaptation in infrastructure development decisions in the Solomons; a full cost pricing algorithm for food and drug regulatory services in Saudi Arabia; or generating savings from waste transfer station closures that fund a ten-year capital works program – Lytton Advisory is up for the challenge. At every stage, it is about driving value for the clients and communities affected by infrastructure.
We are excited about the future for infrastructure, its contribution to sustainable economic and social development, and how emerging economic incentives, new social paradigms and innovative technologies are shaking up these services.
The Economic Society of Australia recently polled a number of senior economists on its National Economic Panel, posing the following question:
“As interest rates are at low levels by historical standards, federal and state governments, despite their public debt levels, should be borrowing more than they currently are to invest in infrastructure”.
Just over 70% of respondents either agree or strongly agree, and on a confidence-weighted basis, 75% agree or strongly agree. This is a rare consensus.
It is worth reading the individual responses. This strong consensus is backed by a requirement for solid cost-benefit analysis, case-by-case consideration of projects and a recognition that any infrastructure spending is not automatically a ‘good thing’.
Do you think we should increase public debt now to invest in infrastructure?
A great collaboration with the Department of Transport and Main Roads and Aurecon.
Lytton Advisory prepared cost benefit analysis modelling of this active transport infrastructure program for TMR, drawing on great research and analysis undertaken by the project team.
Queenslanders will continue to benefit from TMR’s engagement in developing further active transport infrastructure.
Many thanks to all who contributed to this.
Very pleased to see that my colleagues at Queensland Department of Transport and Main Roads and Aurecon will be presenting our analysis on the economic benefits of cycling infrastructure at the National Traffic and Transport Conference of AITPM in mid-August. The abstract is available here:
Image: Southbank, Brisbane. Source: Brisbane Tourism.
In this note we consider there is a 25% possibility that Cross River Rail may fail to achieve a positive economic net present value and explain how we arrive at that opinion.
Building Queensland reported in its cost benefit analysis summary that Cross River Rail produces a Net Present Value (NPV) of $966 million with a Benefit Cost Ratio (BCR) of 1.21. However, its summary did not publish the actual present value totals of the benefits or costs from the study. The full report is not available for public scrutiny. Also, the government’s website for Cross River Rail has still not published the business case.
The BCR was expressed in terms of P50, which implies there is a 50% probability that it could be lower than 1.21. Similarly, if the NPV was expressed as P50 that implies a 50% probability the NPV could be less than $966 million. Interestingly, no formal sensitivity analysis was presented in the summary.
Is it possible to assess the probability that the net present value of the project could be less than zero or the benefit cost ratio less than one?
Using the NPV and BCR information from the summary we calculate the implied present value of benefits (B) and the present value of costs (C). Since NPV = B – C = $966 million, and BCR = B / C = 1.21, we can solve for C. This gives us a present value figure for C of $4,742 million. Therefore, the present value for B is $5,738 million.
Since we do not know the risk profile of these values, let’s assume variability in the estimates are normally distributed around the benefit and cost values implied by the NPV and BCR figures. This is a generous interpretation of the variability of the actual result compared to the estimate because we know that costs are typically skewed towards overruns and realized benefits fall short of estimates more often than exceed them.
We assume a standard deviation that is approximately 20% for each cost and benefit estimate. We assume in the absence of any guidance that the estimate is the mean for the purpose of this analysis. This applies both to costs and benefits. Under a standard normal distribution the estimate statistic is also a P50 estimate.
Benefits and costs in the tails of each distribution are likely to be extreme values. We assume that values in the 5% tails either side of the mean are not sampled. That is, values are drawn from a normal distribution that represents 90% of possible values for benefits and costs.
One final consideration – no correlation is assumed between benefits and costs. What it costs to build and operate Cross River Rail has no influence on the level of demand achieved. The same project is delivered irrespective of cost.
Running @Risk probability software over this, we find that running the NPV calculation through 1,000 iterations there is a 25% chance that the project will generate a negative NPV. No formal consideration is given to optimism bias, which would tend to increase this value.
Is this a risk worth taking? Hard to say because some of the fundamental information is still not in the public domain. Also, components of both benefit and cost may be well identified and estimated. As a consequence, their probability profiles might be within a much smaller range.
Within the project, further work would be required to minimise and mitigate risks that could affect benefit realisation or lead to increased costs. Release of further detail about the project would enable the public to assess this.
Image: Brisbane Times.
Red tape is embodied in regulations created by governments. Best practice in regulation is encouraged through Regulatory Impact Assessment (RIA). In Queensland and across the world, governments use RIA to understand the consequences of changing regulations. RIA’s help decision makers do more good than harm. Cost-benefit analysis is an essential part of that framework.
Different jurisdictions have procedural manuals for how to do RIAs. This provides guidance to analysts. But when a RIA presents you with a lot of technical data, how can you as the decision maker be sure the recommended course of action is the best one?
Thankfully a diverse group of experts convened by the George Washington University Regulatory Studies Center has developed some tips to steer you through the RIA issues.
Next time you change some regulations, ask your regulatory analysts these questions:
- Does the RIA identify the core problem (compelling public need) the regulation is intended to address?
- What role do markets play when assessing regulatory policies?
- When are market forces inadequate?
- Are a lot of anecdotal or unrealistic justifications being supplied?
- Is there an objective, policy-neutral evaluation of the relative merits of reasonable alternatives?
- Does the RIA present a reasonable “counterfactual” against which benefits and costs are measured?
- Do totals and averages obscure relevant distinctions and trade-offs?
- Recognize that all estimates involve uncertainty and ask what effect fundamental assumptions, data, and models have on estimates?
- Is there sufficient transparency and objectivity of analytical inputs
- How do projected benefits relate to stated objectives?
- What is the evidence for and against a causal relationship?
- Does the analysis accurately characterize indirect benefits and costs?
- How does the law of diminishing returns affect the analysis?
- What “costs” are actually being considered?
- When are compliance costs an insufficient proxy for opportunity cost?
- Are estimated marginal costs increasing?
- How are benefits and costs being distributed?
- Are the benefits and costs are presented symmetrically?
Lytton Advisory provides cost-benefit analysis services to support regulatory impact assessment processes that address many of these questions. Contact us today to find out more.
Nothing is more hair raising than exposure to risk without a sense of the level of that exposure. This is especially true in capital investment decisions.
Monte Carlo simulations perform risk analysis by building models of possible results by substituting a range of values—a probability distribution—for any factor that has inherent uncertainty and significant impact on the final result.
By using probability distributions, variables can have different probabilities of different outcomes occurring. Probability distributions are a much more realistic way of describing uncertainty in variables of a risk analysis and improve the quality of sensitivity analysis.
During a Monte Carlo simulation, values are sampled at random from input probability distributions. This is done hundreds or thousands of times, and results in a probability distribution of possible outcomes. It provides a much more comprehensive view of what may happen.
Advantages over deterministic, or “single-point estimate” analysis include:
- Probabilistic Results. Showing how likely each outcome is.
- Clearer Graphical Results. Visual presentation of probabilities.
- Improved Sensitivity Analysis. Sharper sensitivity analysis to show what counts.
- Scenario Analysis: Model repeated variations in combinations of factors to show which scenarios need further investigation.
- Correlation of Inputs. Represent how, in reality, when some factors goes up, others go up or down accordingly.
Done poorly or with low quality input data, the results can be potentially misleading – producing a level of certainty on the basis of some very uncertain assumptions.
Lytton Advisory holds an @Risk software licence which enable us to provide this type of probabilistic analysis to clients, helping them make better informed decisions. Examples of how we have applied this for clients include:
- Estimating financial costs of schedule delay on a major metropolitan public transport project.
- Assessing probability of breaching a cost contingency levels on a +$500 million infrastructure program.
- Building probabilistic NPV profiles in cost benefit analyses given uncertainty about key economic inputs.
Contact us today to find out how we might be able to help you.
The Queensland Government has replaced the former government’s Royalties for Regions program with its own 200 million ‘Building our Regions’ Program and is calling for applications from local councils. See:
A commendable aspect is the requirement to provide a cost benefit analysis on applications for funding over $500,000. Application for amounts below that will still be subject to a benefit analysis.
There are pros and cons with this type of handout – are projects genuinely additional, will co-contributions be effective, is effective, long term infrastructure planning distorted?
However, it can hardly be argued local councils are drowning in funds to invest in infrastructure.
Recognising the Government is looking for shovel-ready projects, applications close 11 September.
Red tape reduction remains on the Government’s agenda in Queensland. Significant work has been done on a social and human services blueprint by the Department of Communities, Child Safety and Disability Services. See:
I am pleased to have played a small part in this. See: