Appendix 1: Principles for assessing costs and benefits - further information
This appendix provided additional information on the principles for assessing costs and benefits:
- Price basis for economic valuation (A1.2)
- What is a benefit and what is a cost? (A1.3)
- Transfer payments (A1.4)
- Discounting (A1.5)
A1.2 Price basis for economic valuation
Economic valuation should be undertaken using real prices; that is, inflation is ignored where 'inflation' has the everyday meaning of the price of a resource increasing without its relative value also increasing. The dates at which any economic data were derived should be established and converted into present values.
Commonly, the relative prices of the different streams of costs and benefits are assumed to be constant over time; this is generally a conservative practice. In reality, they may change over time. Growth factors may be adopted to reflect predicted changes in relative prices or demand. However, if such factors are used for one stream of benefits or costs, they should be used for all streams. Since prices are relative, it follows that, over time, some will fall relative to others. Therefore, any use of selective growth factors should be considered carefully.
Key points are:
- Inflation should be ignored in undertaking the analysis;
- Real prices should be used for all streams of benefits and costs.
A1.3 What is a benefit and what is a cost?
There is no universally agreed basis for classifying a particular item as either a positive cost, or a negative benefit (disbenefit), or vice versa. The particular approach adopted can have a significant effect on the benefit-cost ratio and it is therefore important to have a common rule. The following conventions should be adopted:
- Any 'negative costs' should be regarded as benefits;
- Any 'negative benefits' should be regarded as costs.
The economic benefit for a flood risk management option is the net difference between total present value of damages with and without the option - that is, the damage avoided in comparison with baseline. Any negative benefit, or disbenefit, arising from the option represents a loss to society, and should therefore be treated as a cost. Conversely, resources which become available to society as a result of implementing the option should be regarded as a benefit.
Sales that offset the costs of construction (for example, re-use of material) are to be treated as benefits of the scheme.
Disbenefits such as noise and disruption caused by project works, and obstructions to views, should be treated as costs; but only where these disbenefits are likely to be of significant and where there are significant differences of impact between different options. Otherwise, the costing of the disbenefits is likely to be disproportionate to their magnitude. In general, disbenefits are likely to be better handled when assessing unvalued social and environmental impacts, through which mitigating actions are likely to be identified and included in scheme costs. The residual impact (the impact that remains following mitigation) will need to be described, quantified and, only where appropriate, valued as damages. If mitigation is not possible and actions are required to compensate, then these costs should also be included in the option costs.
Benefit-cost analysis aims to represent the full economic value of the option, and theoretically should include values for indirect and intangible benefits, including those without market value. Further information on the valuation of non-market benefits can be found in HM Treasury Green Book (2011) and supplementary guidance.
Pricing some of these non-market benefits can involve significant resources and it may be proportionate to describe or quantify these impacts instead. Section 11 considers how best to ensure these impacts are still taken into account in decision-making.
Benefit-costs analysis is only concerned with changes in the total value of benefits and the total cost of the resources used. People will often adjust to a flood loss, and do so in a way that minimises their losses. If flooding closes a factory, production may be increased elsewhere and the total national value remains the same. If the alteration simply varies the distribution of benefits and costs across the UK, then no economic change occurs. Changes only in the distribution of consumption and resources are termed 'transfer payments' and should be excluded from the benefit-cost analysis.
A1.4 Transfer payments
When does a change result only in a transfer payment?
Benefit-cost analysis is concerned with national economic efficiency where efficiency is, in effect, the ratio of the value of outputs (consumption) to inputs (resources). These inputs are yielded both from stock (e.g. engineering plant, buildings) and from flows (e.g. electricity, labour).
A transfer payment occurs when a change simply affects either who gets the consumption or who provides the resources, but there is no change in the national total of either all the consumption, or all the resources required to generate that consumption.
Test for a transfer payment
Will there be any change either or both in the total value of UK consumption or in the resources required to provide that consumption? If not, then only a transfer payment is involved.
When a physical object is damaged or destroyed by a flood, a transfer payment is not involved since maintaining current levels of consumption will require the replacement of that object. There will be distributional consequences as well (e.g. builders will get more work) but the test is whether there will be a change in the total level of consumption or the resources required, including the need to repair or replace stocks which have been damaged or destroyed.
Examples of a transfer payment
- VAT and excise duties are always transfer payments and must be netted out of the analysis. If less petrol is sold, then the Exchequer will simply find different ways of raising taxes;
- If a hotel or pub were lost, the trade would simply transfer to other outlets; the value of any such 'goodwill' element in the market price must therefore be netted out of the analysis;
- Losses of trade to commercial or retail outlets will be a transfer payment except in the circumstances given below.
Examples of changes which are not a transfer payment
In some cases, a levy is made in respect of negative externalities, a 'green tax', which is intended to reflect a real economic cost, although otherwise it appears identical to other forms of taxation such as VAT. If, for example, a charge were to be levied on aggregates which reflected the real environmental damage caused by aggregate extraction, this would reflect the additional economic loss resulting from mineral workings. Therefore, an increase in aggregate extraction would result in additional economic losses to the country, in addition to the resource costs of extraction and transportation. Landfill taxes are also a 'green tax' and represent a real economic cost. Ideally, where appropriate, these additional economic losses should be quantified and included in the analysis. However, this is unlikely to be practical for most flood protection schemes and it will normally be reasonable to use the tax rates as a surrogate for the real economic loss in any analysis.
Losses of trade to commerce and retail outlets result in real losses if consumers cannot obtain equivalent goods at the same time and at the same cost. If all three conditions do not hold, an economic loss is involved. However, the normal expectation is that consumers will be able to obtain equivalent goods at no extra cost and therefore any differences will not be worth evaluating.
The test can also be applied to non-priced goods, such as visits to a riverside park. If consumers can go somewhere else and get the same amount of enjoyment at no extra cost, the change in visiting results in no real economic cost. If they cannot, the net value of the loss in enjoyment, plus any increase in cost to the visitor measures the economic loss.
To test the economic efficiency of different options on a comparable basis, it is necessary to discount all of the costs and benefits of the option from the time they arise in the future, to their present value. The standard discount rates recommended in HM Treasury Green Book are 3.5% for years 0-30, 3% for years 31-75, and 2.5% for years 76-125. Where there is reason to believe failure to provide sufficient flood protection could cause irreversible damage in the future, HM Treasury (2008) recommends also using a reduced long-term discount rate of 2.57% for years 31-75 and 2.14% for years 76-125 (and applying a sensitivity test).
Beyond 50 years only large costs and benefits will have an impact and significant time should not be spent estimating these values.
The convention that should be adopted is to take all costs and benefits in any given year as accruing at the midpoint of that year, and to discount all these streams back to their present value at mid-year 0. This is the time at which capital expenditure is also to be taken to start to accrue.
In terms of good practice:
- The test discount rates specified by HM Treasury are to be used for all streams of benefits and costs;
- Each and every benefit and cost should be taken to accrue in the middle of the year when it occurs;
- Present values should be calculated as at the mid-year of year 0;
- A consistent base-year dataset should be established, using relevant uplift factors where required.