Session 5

Dealing with Risk and Uncertainty

Cost Benefit Analysis Course
Magister Perencanaan Ekonomi dan Kebijakan Pembangunan
Universitas Indonesia
Introduction
• Cost Benefit Analysis often requires analysts to predict the future.
• Analyst tends to enter single benefit or cost value, but more formal risk-
based approaches are desirable
• In many situations analysts can be certain that circumstances largely
beyond their clients’ control, such as flood, price changes, etc.à done thru
sensitivity analysis
• If one is willing to assign probabilities of occurrence to each of the
contingencies, then uncertainty about the future becomes a problem of
dealing with risk.
• There are some concepts related to risk and uncertainty in CBA, i.e.
expected value and sensitivity analysis
The Concept of Expected Value
• When facing complicated risk problems, analysts often find it useful to
model them as games against nature.
• A game against nature in normal form has the following elements:
§ states of nature and their probabilities of occurrence,
§ actions available to the decision maker facing nature, and
§ payoffs to the decision maker under each com- bination of state of nature and
action.
• To find the value of the game, we use the concept of expected value
𝐸 𝑁𝐵 = 𝑃! 𝐵! − 𝐶! + ⋯ + 𝑃" (𝐵" − 𝐶" ); or
𝐸 𝑁𝐵 = ∑"#$! 𝑃# (𝐵# − 𝐶# )
Risk-Neutrality and Risk Aversion
• It has traditionally been argued that public sector decision-makers should
evaluate projects and programmes on a ‘risk-neutral’ basis.
• Example:
• Project A has an 80 per cent probability of producing a net present value of $2 million and a
20 per cent probability of producing a net present value of $500,000. The expected net
present value (ENPV) is:
• ENPV = 0.8*$2m + 0.2*$0.5m= $1.7m
• Project B has a 50 per cent probability of resulting in a NPV of $1.8 million and a 50 per cent
chance of producing a NPV of $1.6 million. The expected net present value (ENPV) is:
• ENPV = 0.5 *$1.8m + 0.5* $1.6 = $1.7m

• The risk-neutral decision-maker would be indifferent between these two projects,

despite the difference in variability, and would opt to undertake both, provided
that the projects were not mutually exclusive and there were no budget and
other constraints.
Risk-Neutrality and Risk Aversion
• In summary, a risk-neutral decision-maker values projects and programmes at
their expected values.
• Risk neutrality implies that risk of failure can be ignored; for example, where a
government or large investor can pool risks across a large number of projects, an
unfavourable outcome on one is offset by a favourable outcome on another.
E(U)
Risk averse

Risk neutral

Risk seeker

0 NPV
Example Dealing with Uncertainty

TABLE 1 A Game against Nature: Expected Values of Asteroid Defense Alternatives

Exposure to a Exposure to a
Collision with Collision with an No Exposure to
an Asteroid Asteroid between Collision with an
Larger Than 20 Meters and Asteroid Larger
One Kilometer 1 Kilometer Than 20 Meters
State of Nature in Diameter in Diameter in Diameter
Probabilities of states of nature
(over next century) .001 .004 .995
Expected
Actions (alternatives) Payoffs (net costs in billions of 2000 dollars) Value
Forward-based asteroid defense 5,060 1,060 60 69
Near-Earth asteroid defense 10,020 2,020 20 38
No asteroid defense 30,000 6,000 0 54
Choose near-Earth asteroid defense: Expected net cost ! $38 billion.

Sumber: Boardman et.al. (2014)

their timely use in diverting asteroids from collision courses with Earth; build a near-
Earth asteroid defense, which would be less expensive but not as effective as the
forward-based defense; and build no asteroid defense.
Although actually estimating the payoffs for this game would be a monumental
and controversial analytical task, Table 1 displays some hypothetical figures. The pay-
offs, shown as the present value of net costs over the next century, range from $30 tril-
lion (Earth is exposed to a collision with an asteroid larger than one kilometer in di-
Risk Facing Public Sector Project
• First, when project effects are concentrated on particular individuals or groups, they may
involve large changes in welfare. In this case, a risk-neutral approach may not be
appropriate.
• Secondly, risks facing public sector projects may not be independent.
• The benefits of many public projects, such as roads, airports and power stations are not
independent of cyclical national income and other ‘external’ factors such as climatic conditions.
• In either case, a risk-averse response may be more appropriate than a risk – neutral one.
• Thirdly, separate risky projects may not be ‘pooled’.
• Tax payer’s perspective (owner of project, risk-pooling project) vs. decision maker/project
manager (less project, pressing condition) à risk averse
• Managers act as if they are personally responsible and face some risk that the project is not
successfull.
• Divergent motives: the risk borne by the Government and the taxpayer from wrong decision is
greater than it would otherwise be.
Techniques in Handling Risk and Uncertainty
1. Sensitivity Analysis
• The values included in a cost-benefit analysis are the average estimates (mean).
• The first step in a sensitivity analysis is to substitute pessimistic estimates for
each important variable simultaneously and to estimate a revised NPV.
• If NPV > 0 , even with pessimistic assumptions project is feasible
• If NPV < 0, project is risky to a certain extent
• The second step is to assess how risky the project is and which variables
significantly affect the NPV.
• The value of the variable at which the NPV changes from positive to negative is
known as the ‘switching value’ (partial sensitivity analysis)
• One or two switching variables can be tolerated and adjusted to provide
feasibility. But if there are more than five such variables, there may be many
combinations of the variables that would justify a project, vice versa.
EIRR were examined separately. In addition, a scenario involving non-
linear demand is considered as part of sensitivity analysis to illustrate
the application of the numerical integration approach (as explained in
Section 7.1.3). The sensitivity of the project to key parameters is also
checked by identifying their switching values (that is, how far they have
to rise or fall for the EIRR to reach 12% or the NPV to fall to 0), holding
Techniques in Handling Risk and Uncertainty
everything else constant. Table 7.18 summarizes the results.

Table 7.18 Sensitivity Results: Change in NPV and EIRR, Switching Values
NPV Switching Assumed
Change ($ million) EIRR (%) Value Value
Base case 66.96 17.3
Capital cost 54% 100%
10% 54.58 16.0
20% 42.20 14.9
Fuel 29% 100%
-20% 47.86 15.8
-10% 57.39 16.6
10% 76.56 17.9
20% 86.19 18.6
Income growth 1.027 1.06
1.02 -9.84 10.90
1.10 217.90 23.8
Price elasticlty 0.6326 -0.5
-0.90 109.31 20.1
-0.10 36.37 15.0
Adjusted half 57.72 16.6
VOC savings
EIRR = economic internal rate of return, NPV = net present value.
Source: ADB (2007).

Source: Economic Analysis of Transport Improvement (ADB, 2013)

Techniques in Handling Risk and Uncertainty
2. Full risk analysis
• When there are many uncertain variables, a full risk analysis may be
undertaken.
• In this analysis, probabilities are assigned to the values of all key variables and
estimates made of the covariance of the variables.
• Then, through repeated computer iterations based on a random sampling of
the values of the variables, a probability distribution of the net present value
of the project is generated
• It is worth emphasising that this is the only type of analysis that provides a
comprehensive picture of the potential variability of a project.
• Using Monte Carlo analysis
 GDP growth, annual 2% to 10% (6%)
Price elasticity −0.9 to −0.1 (−0.5)
Capital cost −20% to +20% of base case
Fuel price −50% to +50% of base case
274 Cost−Benefit Analysis for Development: A Practical Guide GDP = gross domestic product.
Source: ADB (2007).

Techniques in Handling Risk and Uncertainty

variation of capital cost and much higher variation of the fuel price are The resulting expected value, that is, the probability weighted NPV is
allowed for, as well as changes in income growth and price elasticity $83.2 million, approximately 24% higher than the base case (Figure 7.3).
of demand. The key result is the probability of project failure, defined by a negative

Table 7.19 Risk Analysis: Parameter Variation Figure 7.3 Risk Analysis: Probability Distribution of NPV
Parameter Range (Base Case) NPV NPV
GDP growth, annual 2% to 10% (6%) -25 242 -25 242
5.0% 5.0%
Price elasticity −0.9 to −0.1 (−0.5) 0.006 1.0

Capital cost −20% to +20% of base case 0.005 0.8

0.004
Fuel price −50% to +50% of base case 0.6
0.003
GDP = gross domestic product. 0.4
Source: ADB (2007). 0.002
0.001 0.2

The resulting expected value, that is, the probability weighted NPV is 0.000 0.0
• The key result is the probability of project failure,

-200
0
200
400
600
800
1000
1200
1400
1600

-200
0
200
400
600
800
1000
1200
1400
1600
$83.2 million, approximately 24% higher than the base case (Figure 7.3).
defined
The key bythea probability
result is negative of NPV. This
project probability
failure, defined byisa negative
NPV NPV
about 10%
Minimum -95.4331
While
•Figure there is no unique cut-off rate for
7.3 Risk Analysis: Probability Distribution of NPV Maximum
Mean
1,564.9006
83.1918
acceptable
-25 242
risk
NPV levels (although 25% isNPV
-25 242
sometimes Std Dev
Values
86.7300
10,000
used as a rule
0.006
5.0%of thumb), the project appears
1.0
5.0% to NPV = net present value, Std Dev = Standard deviation.

be low risk.
0.005 0.8
Source: ADB (2007).

0.004
0.6
0.003
0.4
0.002
0.001 0.2

0.000 0.0
-200
0
200
400
600
800
1000
1200
1400
1600

-200
0
200
400
600
800
1000
1200
1400
1600

NPV NPV
Techniques in Handling Risk and Uncertainty
3. Raising the discount rate
• Another method for allowing for risk is by ‘loading’ or raising the discount rate
• The strategy of loading the discount rate is often used to counter a systematic over-
optimism in net benefit forecasts, especially when late-occurring benefits may be too
high
• The method fails if it is late-occurring costs that are the source of the uncertainty
(produce adverse effect), therefore reduce the discount rate is more appropriate.
• A risk loading is appropriate where there is a constant (exponentially increasing)
probability of a project failing
• Loading the discount rate is not recommended as a general practice for publicly
funded projects.
 However, such circumstances are rare. Generally, a project is more likely to fail during its
set-up period or at the end of its life – for example, as capital equipment becomes obsolete.
Accordingly, loading the discount rate is not recommended as a general practice for publicly
funded projects.

6.6 Sensitivity analysis and discount rates

Sensitivity Analysis and Discount Rate

It is important to extend sensitivity analysis to the discount rate that is applied to the
project net benefit stream. Suppose that a central discount rate of 7 per cent were adopted,
sensitivity testing at 5 per cent and 9 per cent can accommodate uncertainty about the level
77
• It is important toofextend sensitivity
the opportunity cost ofanalysis to the
capital during discount
the project periodrate that is applied to the
ahead.
project net benefit stream.
In addition, use of more than one test discount rate may assist in focusing on key
• Use of more thanuncertainties in cases where
one test discount there
rate are signifi
may assistcant
in differences
focusinginon
in thekey
timeuncertainties
profile of net
benefits of project alternatives.
cases where there are significant differences in the time profile of net benefits of project
alternatives. Consider two projects, A and B. A is characterised by early- Project A
occurring costs and late-occurring benefits, while B is the (+) 4

• Example: opposite – it has late-occurring costs and early-occurring 2

0
benefits (Figure 6.2). At a low discount rate (4 per cent), 2 4 6 8 10 12 14
• Project A early occurring cost and late occurring benefit -2 Time
Project A, with its late benefits, is the preferred choice, (-) -4
NPV ($m)
• Project B early while
occurring benefit
at a high andrate
discount late(12occurring cost B, with its Project B
per cent), Project r A B
early benefits, is the superior option. At a central discount 8 10.0 12.0
• Using 𝑟 = 4% CBA criteria will choose A (+) 4 10 6.7 8.4
rate (8 per cent), Project A is the preferred choice, but only 2 14 3.8 7.5
• Using 𝑟 = 12%marginally:
CBA criteria willpresent
its net choosevalueB is $1.5 million compared 0
2 4 6 8 10 12 14
-2
with $1.4 million for Project
• Using 𝑟 = 8%, CBA will choose A marginally B. However, if the analyst Time
(-) -4
had reason to doubt the magnitude of the net benefits of
• However if the analyst
Project A,has a doubtthat
or considered onthethenetprofile
benefitsof the net
of Project B benefits of6.2project
Figure A, with
Project choice and
contrasting net benefit
believe that the netmay benefits
have been marginally
of project underestimated,
B is marginallyhe or she might
underestimated àtimetheprofianalyst
les
re-examine the analysis and perhaps reach a different
may re-examine the analysis
recommendation.
Optimism Bias
• ‘Optimism bias’ or ‘appraisal bias’ occurs when favourable estimates
of net benefits are presented as the most likely or mean estimates.
• This could be the result of overestimation in future benefits and
underestimation in future costs.
• How to remedy:
• Do sensitivity analysis
• Increase discount rate
• Provide a clear statement of the assumptions in the analysis, particularly
forecasting assumptions, and the reasons for those assumptions.