Guide to COST-BENEFIT ANALYSIS of investment projects - Ramiri

Assessment of acceptable levels of riskWhen individuals attach greater importance to the possibility of losing a sum of money than to the possibility ofgaining the same sum, with a 50% probability of each outcome occurring, there is ‘Risk Averse Behaviour’.Risk aversion follows from the proposition that the utility derived from wealth rises as wealth rises, but at adecreasing rate. This, in turn, comes from the theory of diminishing marginal utility of wealth. In microeconomictheory it is generally assumed that the utility of the marginal quantity of a good is lower than the utility of the samequantity obtained before the marginal one.Figure H.4 Relationship between Utility and Wealth for a risk averse societyUtilityU(W+h)U(W)E(U(W 1 ))U(W-h)W-h W 1W W+hWealthIn figure D.4 the utilities associated with the wealth levels W+h, W and W-h are indicated on the vertical axis. Theexpected utility of wealth for the society if the investment is realised is indicated on the vertical axis as well(E(U(W1)). Since there is a 50% chance of gaining and a 50% chance of losing, the value is exactly in the middlebetween (U(W+h) and U(W-h). But, because of the shape of the utility function (deriving from diminishing marginalutility of wealth assumption), the expected utility of wealth E(U(W1)) will be lower than the expected value of wealth(E(U(W1)) < U(W)). Consequently, the risk averse decision-maker will decide to reject the project. However, for thepublic sector, risk neutrality is to be assumed in general for a risk pooling (and spreading) argument. Under riskneutrality the expected value of the NPV (the mean of probabilities) replaces the baseline or modal estimate of theNPV as a performance indicator. This may also have a substantial impact on the determination of the EU Grant (seean example in Chapter 4, Case Study Water).Risk preventionThe degree of risk is not always the same over the time horizon of the project realization. It has been demonstratedby past experience, and it is generally accepted in literature, that the riskiest phase of a project is the Start-up. At thattime most of the investment costs have been incurred but there may not yet be any feedback from an operationalpoint of view. When the investment enters into the operations phase, the risk involved diminishes because thefeedback becomes increasingly evident.237