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Accounting for systematic risk in benefit-cost analysis: a practical approach

  • Jason Hansen and Jonathan Lipow EMAIL logo
Published/Copyright: October 2, 2013
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Journal of Benefit-Cost Analysis
From the journal Journal of Benefit-Cost Analysis Volume 4 Issue 3

Abstract

Circular A-94 specifies how analysts should discount costs and benefits of government projects, and thus how to account for risk. In this paper, we argue that the methods mandated by A-94 properly account for non-systematic and term risk, but not for systematic risk. A numerical example illustrates how improper accounting for systematic risk produces misleading results and social welfare loss. We conclude by proposing a simple modification of A-94’s procedures that would allow analysts to at least partially account for systematic risk.

Keywords: A-94; benefit-cost analysis; discounting; risk
Corresponding author: Jonathan Lipow, Naval Postgraduate School – Defense Resources Management Institute, 699 Dyer Road, Code 64, Monterey, CA, 93933, USA, Tel: +831.656.3233, Fax: +831.656.2139, e-mail:
  1. 1

    This paper will focus exclusively on the proper discounting of risk in BCA. Procedures for conducting regulatory impact analyses (RIA) will not be addressed.

  2. 2

    See OMB (1992, p. 2).

  3. 3

    See Burgess and Zerbe (2011, p. 1).

  4. 4

    See Bazelon and Smetters (1999, p. 214).

  5. 5

    In this paper, we will make no distinction between BCA and cost-effectiveness analysis. Circular A-94’s methodological guidelines apply to both types of analyses, and there is no meaningful difference in how flows of cash or flows of effectiveness should be discounted.

  6. 6

    Arguments over the proper value for α played an important role in the debate that followed the 2006 publication of the Stern Review on Economics of Climate Change (Stern 2006).

  7. 7

    Evans (2005), for example, estimates η for 20 OECD countries and derives estimates that range from 1.08 to 1.82, with values ranging from 1.15 to 1.45 for the US.

  8. 8

    See OMB (1992, p. 12).

  9. 9

    Ibid., p. 11.

  10. 10

    For an excellent discussion of term risk, see Abel (1999).

  11. 11

    See OMB (2012, p. 12).

  12. 12

    Naval pedants would be correct to point out that, formally, a diesel-electric submarine does not use steam propulsion, and hence cannot “steam.”

  13. 13

    See Bazelon and Smetters (1999, p. 26).

  14. 14

    See Varian (1992, p. 379).

  15. 15

    See Brealey and Myers (1991, p. 200).

  16. 16

    The focus on private consumption implicitly assumes that such consumption is additively separable from all other arguments in citizens’ utility functions. This assumption is regularly made in economic analyses, but cannot be tested or falsified.

  17. 17

    Needless to say, the consequences of such a conflict would be dire for the golf course.

  18. 18

    The correlation is clearly not 1, since there are conditions where consumption could be low while the Korean peninsula remains peaceful.

References

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Published Online: 2013-10-02
Published in Print: 2013-12-01

©2013 by Walter de Gruyter Berlin Boston

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  1. Masthead
  2. Masthead
  4. A cost-benefit analysis of Tulsa’s IDA program
  5. Congressional modification of benefit-cost analysis as a vehicle for particularized benefits and a limitation on agency discretion: the case of the federal contract tower program
  6. Benefit-cost analysis of accelerated replacement of Hong Kong’s pre-Euro IV buses
  7. Accounting for systematic risk in benefit-cost analysis: a practical approach
  8. Benefit-cost analysis: government compensation vs. consumer tax model
  9. Comments
  10. The most appropriate discount rate
  11. The choice of the social discount rate and the opportunity cost of public funds
  12. Erratum
  13. Scitovsky reversals in benefit-cost analysis with normal goods
https://doi.org/10.1515/jbca-2013-0008
Keywords for this article
A-94; benefit-cost analysis; discounting; risk

Articles in the same Issue

  1. Masthead
  2. Masthead
  4. A cost-benefit analysis of Tulsa’s IDA program
  5. Congressional modification of benefit-cost analysis as a vehicle for particularized benefits and a limitation on agency discretion: the case of the federal contract tower program
  6. Benefit-cost analysis of accelerated replacement of Hong Kong’s pre-Euro IV buses
  7. Accounting for systematic risk in benefit-cost analysis: a practical approach
  8. Benefit-cost analysis: government compensation vs. consumer tax model
  9. Comments
  10. The most appropriate discount rate
  11. The choice of the social discount rate and the opportunity cost of public funds
  12. Erratum
  13. Scitovsky reversals in benefit-cost analysis with normal goods
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