Benefit shortfall

Abstract: The assessment of infrastructure investments is often affected by inaccuracy in traffic forecasting, optimism bias and overvaluation of expected benefits. In general, even when such misrepresentation is not strategically introduced by proponents to push their projects, valuators and decision makers must cope with the existence of a risk of demand levels below expectations and consequent problem of overinvestment. In this sense, the concept of option value suggests that flexible or reversible projects may have a higher economic net present value compared with rigid schemes characterised by sunk costs. However, conventionally used cost benefit analysis (CBA) is very seldom used to manage such problem due to the complexity of the issue (for example when introducing a complete risk analysis). Moreover, such CBAs are still conceived as a static tool to decide ex-ante about an investment. In this paper we develop a theoretical framework and a practical application of CBA to formally manage such uncertainty and help the decision makers by postponing some decisions to the following running phase. The idea is to assess the project as split into smaller functional sections and bind the construction of a further section to the compliance of a pre-determined “switching rule”. In practical terms, we adapt a normal CBA procedure to manage also the time dimension of time of investments to reallocate risks already in the early design stage of transport infrastructures. The purpose of the paper is twofold. Firstly, we introduce a way to extend conventional CBA methodology to manage the phasing of projects. Secondly, we demonstrate both theoretically (with a simplified model) and practically (with a more complex case study) the positive effect of phasing under certain conditions (limitedness of sunk-costs due to phasing, predominance of capacity problems). By numerically developing the CBA of the Turin – Lyon high speed rail project, we show how to reduce the risk of overestimation of traffic and its positive effect in terms of NPV of the project: if forecasts are optimistic, only the most effective parts of the scheme will be built. If the traffic forecasts are correct, the new infrastructure will be built as a whole in steps and will generate the highest net benefits.

Abstract: Some years ago I was threatened by a high-ranking government official as I was beginning research on cost overrun in large public works projects. The official told me in no uncertain terms that I came up with results that reflected badly on his government and its projects he would personally make sure my research funds dried up. I replied that he had just demonstrated that research had to be done and was likely to produce interesting results. The results are now being published and if the official walks his talk, I will never receive another research grant.