Guide to COST-BENEFIT ANALYSIS of investment projects - Ramiri

very important aspect is the compromise to be made between high risk projects with high social benefits,on the one hand, and low risk projects with low social benefits, on the other.Generally, a neutral attitude towards risks is recommended because the public sector might be able to poolthe risks of a large number of projects. In such cases, the expected value of the ERR could summarise therisk assessment. In some cases, however, the evaluator or the proposer can deviate from neutrality andprefer to risk more or less for the expected rate of return; there must, however, be a clear justification forthis choice (for example, a very large project in a small country).FOCUS: RISK AVERSION AND PRECAUTIONARY PRINCIPLETo illustrate this concept one can consider innovative projects, which may be more risky than traditional ones. If, for example,these have only a 50% probability of achieving the expected results, then their net social value, for an investor who is neutral torisk, should therefore be halved. However innovation itself is sometime an additional criterion of preference: in that caseinnovative projects must be evaluated by awarding a prize to well-deserving ‘innovation’ and by not overlooking the risk.However, in the case of projects introducing new technologies with a potential risk of harm to the environment and/or publichealth, a strong aversion to risk is usually adopted, despite lack of scientific certainty about the likelihood, magnitude, or causeof that harm (precautionary principle).2.6.5 Risk preventionA typical source of forecasting mistakes in project appraisal is optimism bias, i.e. the demonstratedsystematic tendency for project appraisers to be over-optimistic about the estimation of the key projectparameters: investment costs, works duration, operating costs and benefits (UK Treasury Green Book,2003).Many causes may be involved in optimism bias; Table 2.16 provides some examples for transport projects.Table 2.16 Causes of optimism biasCauses of optimism biasExamplesImperfect information such as unavailability of data, new or unproven technology.Scope changes such as changes in relation to speed, road width, routing, safety, andTechnical causesenvironment norms.Management issues such as inappropriate calculation approach, procurement issues andrisk sharing.Psychological causesTendency for humans and organisations to favour optimism.Economic causesConstruction companies and consultants have interests in advancing projects.Interests, power and institutions.Political-institutional causesActors may deliberately lie in order to see their project/interest realised.Source: UK Treasury Green Book 2003To minimise the level of optimism bias, specific adjustments in the form of increased cost estimates anddecreased, or delayed, benefit estimates should be made. Such adjustments should be empirically based,for example using data from past or similar comparable projects, whilst experts’ consultancy may also beuseful (see also Annex H).Adjusting for optimism bias will therefore provide better estimates at an early stage of the appraisalprocess. However, these adjustments should not be seen as a substitute for risk assessment, but rather as amore accurate basis on which to develop risk analysis, which in principle is all that one would need, ifconducted accurately with the use of expected indicators. Risk analysis should then be the basis for riskmanagement, which is the identification of strategies to reduce risks, including how to allocate them to theparties involved and which risks to transfer to professional risk management institutions such as theinsurance company.Risk management is a complex function, requiring a variety of competences and resources, and it can beconsidered as a role for professionals, under the responsibility of the managing authority and the63