Cost Benefit Analysis

What is cost benefit analysis, and does it have a role in development appraisal? Adrian Hack shares the details.

Development is usually characterised by developers putting forward proposals for the development of property. These proposals are assessed by governments on their compliance with plans, policies and merit, as dictated by planning legislation.

The government bodies then determine whether to permit development, permit development under certain conditions, or refuse it outright. Assessing proposals usually involves checking compliance with a list of codes and other matters for consideration (impacts).

What if a proposal undermines one or two matters on the checklist— should it be refused? What if its benefits far outweigh its costs? All of us would agree that in some cases, the best decisions are not always made from this process. Therefore, economics as a science might provide an alternative method for valuing the worth of a development proposal.

ECONOMICS

Economics is the science dealing with the production, distribution and consumption of wealth in society. Generally there are two broad goals in economics: Optimality (increase welfare using fewer resources) and equity (relating to the distribution of that wealth).

HOW IS THIS RELATED?

Property developers are ‘producers’ of wealth for supply to ‘consumers', and producers are motivated by profit. Freedom of production and consumption is important in creating wealth and moving towards optimality.

However, sometimes there are market failures where optimality and/or equity are undermined. The role of government is to address these market failures, which includes regulating the market and the production of public goods (amongst other measures) to ensure the two broad goals of optimality and equity are better addressed. A common area of market failure occurs when there are impacts on the wealth of third parties — this is the reason for development assessment.

ECONOMIC APPRAISAL

Economic appraisal refers to valuing the wealth of a project. Can we use this as a tool for planning and development assessment? I believe so. Will it improve decision making? Yes, it could. But we must be careful of pitfalls.

There are two main methods for economic appraisals: Cost benefit analysis (CBA) and cost effectiveness analysis (CEA). CBA quantifies both costs and benefits and CEA quantifies only the costs. CEA is about finding the most cost effective method for achieving the project objectives.

There are various guidelines on economic appraisals including the Australian Government Handbook of Cost Benefit Analysis and the New Zealand Treasury Publication Cost Benefit Analysis Primer. There are also various state government guidelines, such as the NSW Government Guidelines for Economic Appraisal. All these documents are downloadable from government websites.

COST BENEFIT ANALYSIS

The Australian Government Handbook describes CBA as follows: "Cost-benefit analysis is a method for organising information to aid decisions about the allocation of resources. Its power as an analytical tool rests in two main features:

  • Costs and benefits are expressed as far as possible in money terms and hence are directly comparable with one another; and
  • Costs and benefits are valued in terms of the claims they make on and the gains they provide to the community as a whole, so the perspective is a ‘global’ one rather than that of any particular individual or interest group".

HOW IS CBA DIFFERENT TO FINANCIAL APPRAISAL?

The value of property is based on its highest and best use, which may be the ‘as is’ use of the land or its redevelopment potential. The redevelopment option is modelled using a static or discounted cash flow model to derive a residual land value.

Hurdle rates are selected to reflect the level of risk; however the important consideration is that the modelling is done from the producer’s point of view. This is not the view of the consumer, third parties or government. In the current model, the forecast cash-ins and cash-outs are the developer’s financial cash flow. There may be lots of other impacts that are not represented.

In CBA, we include all these other impacts that affect all sectors of the economy. This includes impacts on third parties, which are referred to as ‘externalities’. The method of CBA is much the same as financial appraisal. It involves setting up a discounted cash flow model to calculate the net present value of the project. However, in CBA we add all the other costs and benefits, including the externalities that have been quantified into the model through the life of the project.

COSTS AND BENEFITS

The guidelines mentioned above go into some detail about the techniques for quantifying costs and benefits, describing them as either ‘quantifiable’ or ‘unquantifiable’. Quantifiable is when there is direct market evidence, whereas unquantifiable could refer to such things as beauty, ecology, etc.

We are all familiar with CBA being used to evaluate government projects such as hospitals, main roads and train lines. Here I would like to show some examples of where CBA can be a useful tool in planning assessment and in valuing the worth of a privately sponsored project. One such project is the $150m Jack Nicklaus Golden Bear Golf Resort, proposed in Pokolbin in the Hunter Valley. This is a proposal for a resort that includes an 18-hole world championship golf course, golf academy, 250-room hotel, reception/conference centre, wellness centre and 300 residential homes.

The project would provide a third championship golf course to the local area and a world standard golf academy. The benefits of tourism and employment generation in the area would be significant and these benefits would flow through to the other sectors of the Lower Hunter. An important first step in the CBA is to identify the base case. CBA is a tool for evaluating options.

Even if there is only one development option, there is a base case sometimes referred to as the ‘do nothing’ option, against which the preferred option is measured. In the above case, the land was valued for agricultural purposes, and this was inputted into the cash flow model as an upfront opportunity cost of the land. The other costs identified and quantified were capital costs, including design and construction.

The benefits of the project included market rent of the accommodation and industry value add (contribution to GDP) from the various employment generating land uses, based on estimated revenue projections and/ or employment numbers. We also put a terminal value at the end of the project life by capitalising the annual net benefit at 15%.

The real costs and benefits (inflation ignored) were put into a 20-year cash flow model and discounted at 7% per annum, in line with NSW Treasury Guidelines, where 7% is considered a reasonable cost of capital and real social time preference rate (reflecting the desire to consume now rather than later). Some guidelines don’t recommend a constant rate, but rather a rate that reflects the riskiness of the option.

Similar to financial appraisals, there are methods of risk assessment including sensitivity testing, scenario and probability analysis. In the case of the Pokolbin resort, the results demonstrated significant value adds to the economy resulting in a NPV of $226m above the base case. This was well over the financial returns to the sponsors, largely because of the strong beneficial externalities.

There are many other costs and benefits that can be quantified. Travel time and travel cost savings, accident cost savings, use benefit/ opportunity cost of leisure time, amenity (shifts on property values), etc. These are some of the techniques that Hill PDA has used in quantifying impacts in past projects.

POTENTIAL PITFALLS

There are potential pitfalls in CBA, and there are rules to avoid them relating to the treatment of all sorts of items including, for example:

  • competitive impacts transfer payments (e.g. stamp duties)
  • double counting
  • taxes
  • interest cost
  • multiplier impacts (or input output analysis)
  • with/without scenarios versus before/after effect
  • marginal versus average costs and benefits
  • opportunity cost versus sunk costs

The rules relating to these items can be found in the government guidelines. In particular, when assessing a CBA itself, it is necessary to appreciate the inclusions of costs and benefits, methods of quantification, and treatment of variables to ensure that the analysis has been done as objectively as possible. CBA has some strong critics, and there is plenty of literature on this. Apart from some of the above pitfalls, perhaps the two biggest arguments against CBA relate to the equity issue and the ‘monetising’ issue.

THE EQUITY ISSUE

There are two broad goals in economics — optimality and equity. CBA is generally used to measure the former, but not the latter. Critics argue that a decision that takes $100 from a poor person and returns $200 to a very rich person is not a good outcome.

It’s a move away from optimality because the value of the $100 loss to the poor person far outweighs the value of the $200 gain to the rich person, even though it shows net positive $100 on the bottom line. There is the counterargument known as ‘Kaldor Hicks Compensation Principle.’ Evaluators need to be mindful that a project may show a strong net positive benefit, but its distributional impacts may be regressive.

THE MONETISING ISSUE

The other main criticism is that CBA attempts to monetise (convert into dollars) all sorts of impacts, including environmental and social impacts. Critics say you cannot and you should not put a price on the priceless. The ‘cannot’ meaning that it’s impossible, the ‘should not’ meaning that it is unethical.

Typically CBA is used to put a monetary value on all sorts of things, such as the wilderness, ecology, art, archaeological items, health and even human life. And all this becomes an ethical slippery slope. Even when a CBA qualifies, rather than quantifies, one or more costs, critics claim that the bottom line money value appears to overwhelm and disguise what may be significant non-financial costs.

The counter-argument from CBA advocates is that society has to make decisions about where to allocate limited resources, and the evaluation of those options involves weighing costs and benefits (quantitatively or qualitatively). Even when it comes to human lives, society has to make choices about where to allocate resources. This is an inescapable fact of life, and CBA offers an objective method to do this.

In case you haven’t noticed, this is an old ideological battle between Utilitarian and Kantian ethics. Notwithstanding this debate, it’s important to remember that CBA does not make decisions, it is an evaluation tool. A positive CBA does not automatically mean approval. In the recent case of Bulga Milbrodale Progress Association Inc v Minister for Planning and Infrastructure and Warkworth Mining Limited [2013] NSWLEC 48 — the court refused the expansion of an open cut coal mine, notwithstanding its high positive NPV. The Court ruled that:

The IO analysis and the BCA provide only models, and that they are a guide to, but not a determinant of, an assessment of the impacts of the Project.

So as an evaluation tool, CBA can be used to assist in decision making, as can other tools.

OTHER EVALUATION TOOLS

Other evaluation tools that can be used in development assessment include planning balance sheet (PBS), triple bottom line assessment (TBL) and the goals achievement matrix (GAM).

Personally, I’m an advocate of CBA, though these alternative methods certainly have their benefits. PBS, for example, addresses the distributional impacts of a proposal. Be aware, however, that there are champions of alternative methods that claim they overcome the problems of CBA. TBL advocates often claim that it is better than CBA because it doesn’t try to monetise the social and environmental impacts. However, in the end no method can escape the need for these impacts to be weighed.

And TBL’s subjective weighing of financial, environmental and social impacts is less objective than CBA. If there is a conclusion to all this I would say that CBA, which has been used extensively for publicly sponsored projects, is also a useful tool for appraising privately sponsored projects. The decision to use CBA should be made on the size and nature of the project, and the stage at which a decision is sought. CBA should be part of any planning proposal or re-zoning application.

It should also be submitted with development applications for major projects. Determining authorities can request applicants to submit CBAs with their proposals, but they will also require some expertise when it comes to appraising the appraisal.