In a week where the government has cut huge swathes of HS2, economic appraisal is in the spotlight again.
Cost benefit analysis is the widespread tool used to assess the economic impact of public investment projects across government. It compares the benefits of a decision to its costs to understand whether it provides value for money. The principle of CBA is simple, akin to weighing the pros and cons of a decision. It works well when the costs and benefits can be quantified with certainty. In many situations, however, both are hard to define, let alone quantify. Bent Flyvbjerg, an expert on major projects, has done a lot of work to demonstrate that we tend to systematically underestimate costs and overestimate benefits.
In our complex world, it is impossible to estimate costs or benefits with certainty. Variables such as project impact on land values, time savings or environmental changes are too uncertain to assign precise figures. While some schemes undertake sensitivity testing, it’s not universal and often not a major consideration.
This is not to say that CBA lacks merit. Like any model, CBA can provide valuable insights. In their book Radical Uncertainty, John Kay and Mervyn King view CBA as a way to structure thoughts, considering pros and cons, rather than determining precise outcomes. In their view, due to the deep uncertainty inherent in these type of calculations, cost benefit can be only be useful for thinking about the order of magnitude of the aspects involved to see whether we can believe that the investment is worthwhile, rather than putting a precise value on a scheme.
A more circumspect view of CBA might be healthy. There are lessons from other disciplines that might be relevant.
In finance, people often talk about upside bets. Looking for opportunities that might not perform well on average but have large potential upsides if they go well. This is the rationale of much venture capital investments in small businesses. The UK’s approach to appraisal is currently focused on estimating the average outcome for proposals – if we instead considered the potential upside, might that change how we look at an investment?
Entrepreneur and author Matt Watkinson suggests it is also important to consider the downside: ‘affordable loss’. Instead of obsessing over returns, entrepreneurs focus on how much they are willing to lose. He says this “limits their downside, keeps their plans flexible and stops them throwing good money after bad.” HS2 anyone?
Another idea from finance is hedging. We often present options as alternatives. You chose one or the other. This might make sense for large investments – you don’t want two competing railways – but, in an uncertain world where we don’t know what the outcome will be, investing in two potentially competing ideas might make sense. For example, a local area might be putting a lot of their investment into a specific opportunity sector. It is worth considering other sectors to reduce their risk.
Nassim Taleb, author of The Black Swan, explores the concept of ruin – catastrophic and unpredictable events with extreme consequences, such as financial crashes, pandemics, natural disasters and climate change events. Traditional risk assessment methods, like CBA, rely on historic data and predictable outcomes. Attempting to predict the outliers that can lead to ruin is impossible due to their rarity and the complexity.
Applying an uncertainty lens to economic appraisal encourages different perspectives and reduces the risk of failure. CBA should be a tool for considering the type and scale of potential benefits, not for assessing precise outcomes. Instead of fixating on average results, embracing diverse strategies, taking calculated risks, considering downsides and being mindful of potential ruin can pave the way for a more resilient and adaptable decision making process.
At Volterra we advocate for simple, transparent models that weigh both upside and downside risks. Any model must be accessible to all and be accompanied by a clear narrative. Only then can we facilitate meaningful debate and enable better decision making.
Alex O’Byrne, Partner
