Government Capital Project Appraisal - No Room for Optimism

Ideally CPAs should always include an assessment of value for money of the options being considered. This may sometimes be wholly in financial terms—e.g., in comparing the costs of different ways of providing the same output. More often it will entail some factors which can be quantified but not valued, or which cannot even be quantified (e.g., environmental concerns), and about which explicit judgments have to be made.

CPAs should also include an analysis of the budgetary implications of a proposal over time. This may need to include an analysis for the public sector as a whole as well as for the spending department or agency directly involved. The information provided by this analysis, or by the examination of other institutional constraints, may in the end determine the final decision.

The UK’s solution to address the “Optimism Bias” in CPAs
Generally, the UK Treasury and Departments found that there is a demonstrated and systematic tendency for capital project appraisers to be overly optimistic.[3] To redress this tendency, CPA appraisers are instructed to make explicit, empirically-based, adjustments to the estimates of a project’s costs, benefits, and duration. In order to make the necessary adjustments, CPA appraisers are instructed to keep these two factors in mind: (i) make adjustments to the estimates of capital and operating costs, benefits values and time profiles; and (ii) provide a better estimate of the likely capital costs and works’ duration. The UK Treasury and Departments use adjustment percentages for generic project categories in the absence of more robust evidence. The adjustments used have been prepared from the results of the MacDonald study[4] into the size and causes of cost and time overruns in past capital projects.

The “Green Book” recommends five key steps, as set out below, to derive the appropriate adjustment factor to use for capital projects: STEP 1 – Decide which project type(s) to use. STEP 2 – Always start with the upper bound. STEP 3 – Consider whether the optimism bias factor can be reduced. STEP 4 - Apply the optimism bias factor. STEP 5 - Review the optimism bias adjustment.

Following the above steps will provide an optimism bias adjustment that can be used to provide a better estimate of overall costs. Sensitivity analysis could be used to consider uncertainties around the adjustment for the optimism bias. Generally, if the optimism bias at the appraisal stage is appropriately low, then the project would be allowed to proceed. If the optimism bias remains high, then approval could be withheld, or granted on a qualified basis (e.g., requiring further research, costing and risk management).

Requirements for Effective CPA Procedures
In many countries, “readiness” of the project to move forward can become a more important consideration than its strategic or economic value. For example, given that EU project funding lapses after a predetermined period, developing countries receiving aid from the EU face pressures to make sure that they have a group of projects ready. This can have the effect of creating a perverse incentive in that governments fear losing these funds if they are unable to spend them. It seems it is better to spend the money on sub-optimal projects rather than risk losing the funds and having no project. Inevitably, some preparations take longer than expected once the funds are available. External review before projects start is a tool used for guarding against such processes. Special reviews have also helped identify the main causes contributing to systemic under-estimation of project costs. It would appear that a consistent use of the “optimism bias” correction could further improve the external review processes.

In summary, a number of general requirements for effective CPAs could be defined:

• well-informed and open-minded consideration of alternative options, against well-defined policy objectives;

• taking proper account of opportunity costs (so that the use of labor, for example, is normally recognized as a cost, and not seen instead as a benefit);

• addressing any “optimism bias” as to ensure the proper calculation of all overall costs; and

• consideration of factors which cannot be explicitly valued in money terms as well as those which can.

This contrasts with what is often understood by CPAs in low-income countries, which is a cost analysis of an already well-defined proposal. The capacity of some low-income countries to undertake such an analysis is often strong, whereas the capacity for economic analysis, to question initial proposals, might be weaker.
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