· web viewvictorian guide to regulation updated july 2014, toolkit 2: cost-benefit analysis i 2...

Victorian Guide to RegulationUpdated July 2014Toolkit 2: Cost-benefit analysis

The SecretaryDepartment of Treasury and Finance1 Treasury PlaceMelbourne Victoria 3002AustraliaTelephone: +61 3 9651 5111Facsimile: +61 3 9651 5298www.dtf.vic.gov.au

Authorised by the Victorian Government1 Treasury Place, Melbourne, 3002

© State of Victoria 2014

This work is licensed under a Creative Commons Attribution 3.0 Australia licence. You are free to re-use the work under that licence, on the condition that you credit the State of Victoria as author. The licence does not apply to any images, photographs or branding, including the Victorian Coat of Arms, the Victorian Government logo and the Department of Treasury and Finance logo.

Copyright queries may be directed to [email protected]

ISBN 978-1-921831-51-5Published August 2011

If you would like to receive this publication in an accessible format please email [email protected]. This document is also available in PDF format at www.dtf.vic.gov.au

mailto:[email protected]

http://creativecommons.org/licenses/by/3.0/au/

http://creativecommons.org/licenses/by/3.0/au/

An appropriate citation for this publication is: Government of Victoria, 2011, Victorian Guide to Regulation, Department of Treasury and Finance, Melbourne.

Contents

1. Steps in undertaking cost-benefit analysis........................................................11.1 Identifying groups that will be affected......................................................................................11.2 Types of costs and benefits........................................................................................................21.3 Key issues to consider................................................................................................................61.4 Decision criteria.........................................................................................................................8

2. Enhancing decision-making in the absence of a full cost-benefit analysis............................................................................................................12Break even analysis..........................................................................................................................12Cost-effectiveness analysis...............................................................................................................13Multi-criteria analysis.......................................................................................................................14

Attachment 1. Competition test assessment.........................................................17Stage 1: Identify the restriction on competition...............................................................................17Stage 2: Show that the restriction is necessary to achieve the objective.........................................19Stage 3: Assess whether the benefits of the restriction outweigh the costs....................................19

Victorian Guide to RegulationUpdated July 2014, Toolkit 2: Cost-benefit analysis i

1. Steps in undertaking cost-benefit analysis

OverviewThe process of systematically evaluating and assessing the costs and benefits of a regulatory proposal is known as cost-benefit analysis (CBA). CBA makes it possible to determine whether a proposal has a net benefit, i.e. whether the benefits outweigh the costs and to compare alternative proposals to identify which one has the greatest net benefit.

A key aspect of LIAs and RISs involves the assessment of the costs and benefits of all options. This is a critical step in determining the preferred option.

The CBA should be consistent with a proportional approach. Key steps involved in undertaking a CBA are:

identifying groups that will be affected;

identifying and assessing costs and benefits from options being considered for addressing the problem;

consideration of other issues, such as discounting of future costs and benefits; and selecting and applying appropriate decision criteria to assess the relative effectiveness of or

to rank options.

1.1 Identifying groups that will be affected The groups of society that are likely to be affected by the viable options need to be identified, so the impact (both costs and benefits) on these groups can be highlighted. This will assist in:

improving understanding about the potential impacts of the options, including unintended consequences;

identifying key stakeholders; and gathering information on the costs of the options.

The primary groups that should be considered are business, consumers/individuals and government. These groups may be broken down into sub-groups where there are likely to be differential effects from a proposed measure – for example, there may be differences between the impact on consumers in urban and rural areas, or for small firms relative to large firms.

Examples of different sub-groups for group impact analysis Business: large, medium, small businesses; importers, exporters and/or firms supplying the

local market; business located in urban areas; businesses with regional and/or interstate or international operations;

Consumers/individuals/groups: individuals with different age, language, physical, cultural, location (urban/regional), gender, family or income/wealth characteristics; consumers with different levels of information; community groups such as sporting clubs, charities, churches; and

Government: Commonwealth, state/territory, local government; statutory bodies.

Victorian Guide to RegulationUpdated July 2014, Toolkit 2: Cost-benefit analysis 1

Stakeholder consultation on impacts of proposals is critical for the development of LIAs and RISs. Planning for early engagement with affected parties is particularly beneficial to ensure that information is relevant and accurate and that all issues and risks are taken into account during the policy development process. It should also be noted that under section 6 and section 12C of the SLA, a RIS requires consultation with any sector of the public on which a significant economic or social burden may be imposed by a proposed regulatory measure.

1.2 Types of costs and benefitsAn assessment of the costs and benefits (the ‘impacts’) arising from the viable options is the central analytical component of the RIS and LIA. It is this assessment that provides evidence that the benefits of government intervention outweighs the costs, and helps identify which of the options is likely to provide the greatest net benefit to society as a whole.

Clearly, it is important to identify the full range of costs and benefits that could potentially arise from the different options and, where possible, quantify such impacts by assigning dollar values to these costs and benefits. Some possible sources of information to help with this task are:

consultation with those likely to be affected; experience in other jurisdictions;

knowledge and experience of government departments (e.g. based on similar regulations in other areas);

surveys – either existing or commissioned; consultants and academics;

research documents, market reports, internet searches about the affected sector; data held by agencies, such as investigations of complaints, audits;

insurance claims data; and national statistics on economic indicators (e.g. size of the economy, number and sizes of

firms, earnings, hours worked, production, consumption, regional trends, social trends, imports and exports).

As discussed in Section 2 of the VGR, the amount of work undertaken to assess costs and benefits should reflect the expected size of the impacts. Proportionality guidance has been incorporated into the VGR for key steps in the LIA/RIS process, including assessing the costs and benefits of options.

In identifying the impacts, it is useful to make a distinction between the following different categories of costs and benefits (while recognising that there may be overlaps between the categories):

economic and financial impacts (within this category, the costs associated with administration, compliance and enforcement must be identified separately);

social impacts; and

environmental impacts.

The guidance material below also includes information about the full range of possible costs to consider when examining options to deal with public risk.

2 Victorian Guide to RegulationUpdated July 2014, Toolkit 2: Cost-benefit analysis

Economic and financial impacts Economic and financial impacts represent the broadest category of costs and benefits. They typically relate to goods or services exchanged in the marketplace (or for which a market value can be derived directly).

While the impacts will clearly depend on the specific nature of the option being assessed, Table 1 below lists some examples of economic/financial costs and benefits that may need to be considered in the CBA.

As shown in Table 1, the costs of administration, compliance and enforcement associated with the proposed options should be included within this category. The methodology outlined in the Regulatory Change Measurement Manual may be used to measure the regulatory costs of the different options.

Table 1: Examples of economic/financial costs and benefits

Group Examples of costs Examples of benefitsBusiness Additional costs incurred arising from

changes required to production, transportation and/or marketing procedures

Licence fees or other charges levied by government

Higher input costs, including the additional costs of shifting to other sources of supply

Costs resulting from delays in the introduction of goods or services to the marketplace and/or restrictions in product availability

Costs associated with lower productivity because the proposed measure causes diversion from ‘core’ business activities

Costs of time and legal/consultancy fees required for familiarisation with regulatory requirements

Additional reporting requirements and other paperwork associated with administrative burden

Costs of internal inspection, monitoring, audit fees and legal fees to ensure compliance

Benefits arising from increased efficiency/productivity as a result of the measure, which may emerge in the form of reductions in costs due to the removal of restrictions on competition and/or removal of marker power of an input supplier

Reductions in workplace accidents and injuries, and healthier workforce (increased human capital)

Improvements in market information

Ability to take greater advantage of economies of scale

Consumers Higher prices for goods and services Reduction in the quality or choice of goods

and services Delays in the introduction of goods and

services and/or restrictions in product availability

More difficult or more expensive options for seeking redress

Lower prices for goods and services (e.g. due to the removal of restrictions on competition)

Improved safety of goods and services

Increases in the quality and choice of goods and services

Provision of greater information about goods and services


Group Examples of costs Examples of benefitsGovernment Same as costs listed under ‘business’ to the

extent that the proposed measure applies to the government sector, including local government

Administration costs (e.g. processing of permits and applications, publicity and guidance, advice lines)1

Enforcement costs incurred by regulator (including any legal expenses)

Implementation costs to government enforcement agencies. If local government is to administer/enforce regulation, costs of training and assistance that will be made available to local government

Improvements in public health, resulting in lower costs to the public health system and worker compensation payments (e.g. where regulation is to improve health and safety)

Improved information to the government

Social impactsWhile consideration of the economic and financial impacts of the viable options tend to dominate the CBA – not least because they lend themselves more easily to quantitative analysis – it is important to recognise any social costs and benefits that might arise.

The following examples are the types of questions that can assist with the identification of potential social impacts:

Does the proposed measure create opportunities for increased leisure time?

Will the proposed measure affect the health of the community? How will the proposal affect levels of skills and education?

Will the proposal affect the provision of facilities or services that support community cohesion or in other ways that affect the quality of life in the local community?

Will the proposal affect the rate of crime or crime prevention, or create a new offence/opportunity for crime?

Valuing social impacts presents a challenge because it is often difficult to assign a market price to them. However, it is often possible to derive notional market prices via indirect means. For example, valuing the cost of an increase in crime could be derived from increases in insurance premiums to cover theft.

Even in those cases where it is difficult to value social impacts, it may be possible to provide an indication of the impact by looking at impact measures other than value. For example, this might involve the provision of information such as: how many people will be affected; what type of people might be affected; and the nature and impact of some of the effects.

Such analysis can allow notional indicators of impacts to be provided. In other words, effects may be categorised as ‘small’, ‘medium’ or ‘large’, to enable comparison and weighting of various social impacts.

1 Double-counting should be avoided here. Sometimes, fees may be charged to cover administrative costs. Thus, these costs should only be included to the extent that the fees charged do not cover the cost of administration.


Sometimes, it may be difficult to assign dollar values to benefits, while cost estimates are more readily available. In such cases, benefits may be expressed in terms of physical units (e.g. the number of lives saved, the number of accidents prevented), while costs are expressed in dollar terms. This type of analysis is sometimes referred to as cost-effectiveness analysis – i.e. it assesses the comparative cost of achieving a given level of a desired outcome.

In assessing social impacts, care should be taken not to include redistributive effects as a social benefit where these are merely redistributing from one group in society to another, unless there is some indication that a dollar is more valuable for one group than another.

Environmental impactsConsideration must also be given to any environmental impacts that may arise from the proposed measure. For example, will the proposed measure:

involve the utilisation of a substantial volume of natural, non -renewable resources, including land?

result in a change in air pollutants or harmful emissions and/or the population affected by air pollution?

result in water pollution and/or the population affected by water pollution? disturb habitats or species?

have impacts on natural, cultural and/or heritage values? affect the number of people exposed to noise or the level of such exposure?

As with social costs and benefits, assigning values to environmental impacts presents a number of methodological challenges. Nevertheless, analytical techniques have been developed to assist with such valuations, and this may be useful in certain circumstances (e.g. hedonic pricing, contingent valuation, damage cost avoided).

Costs of public risk regulationIn the area of public risk regulation, policy-makers arguably face pressure from the public to quickly respond to risk with prescriptive forms of regulation without fully considering all the costs associated with such approaches. This may be due to difficulty or resistance to discussing the cost of reducing harm to individuals in financial or economic terms.

Public demand for regulation may also challenge the development of policy that is based on the full evaluation of costs and benefits where public perceptions of the magnitude (likelihood and consequences) of different public risks varies from an objective evaluation and ranking of these. There is considerable evidence to suggest that people may systematically overestimate some risks and underestimate others. People are likely to experience disproportionate anxiety about, and demand strong regulatory responses to, risks that are ‘dreaded’ and ‘unknown’, including those that are highly visible or publicised. By contrast, those risks that are well known, less frightening or more routine, such as car accidents or health conditions caused by lifestyle factors, are likely to be more easily accepted, despite the actual risk of harm they pose. Demand for public risk regulation is likely to reflect these biases. For example, the occurrence of a tragic accident could give rise to demands for swift and decisive regulatory intervention to eliminate future accidents, even where the probability of such incidents is relatively low or the likely effectiveness of regulation in achieving risk reduction is limited.

In the context of these pressures, it is important that policy-makers do not fail to consider the full range of possible costs when examining the need for public risk regulation, and in considering the relative impacts of other approaches to dealing with public risk.


The costs of public risk regulation include market distortion costs that may take a number of different forms, including: costs of constrained innovation: prescriptive public risk regulations – which define how

producers operate or the types of products/services they offer – restrict the ability of producers to develop new goods and services, or adopt new production techniques (e.g. new technology). Regulations that place conditions on the way goods or services are provided, or which mandate the use of particular techniques, can ‘lock in’ old approaches and make the adoption of innovative approaches or development of new goods and services difficult. This effect is sometimes known as the ‘dynamic cost’ of regulation;

restrictions on consumer choice: often, public risk regulations restrict the ability of consumers to choose the price or quality, range, or location of the service they use. This could prevent consumers from choosing a lower standard, cheaper service in cases where they do not need the higher quality service. It can also disadvantage consumers that do not have access to regulated locations. Minimum quality regulation of supported residential services and child care both clearly fall in this category. Importantly, the costs of complying with quality regulation can flow through to higher prices. If changes to relative prices are significant, consumers may respond by changing their consumption. This could potentially lead to perverse outcomes if it causes consumers to substitute less preferred and potentially more dangerous alternatives; and

costs of reduced entry and exit in the regulated market: by imposing the need for licences, accreditation, or by otherwise increasing the cost of establishing or operating a new enterprise, public risk regulations can represent impose a barrier to entry, and allow existing operators to enjoy a significant competitive advantage over new entrants. By reducing the likelihood that new players will enter a market and attract customers away from incumbent operators, such restrictions weaken the incentives of existing providers to improve efficiency and minimise prices, and respond to the demands of customers.

Risk regulation may also impose costs on third parties – i.e. those not directly involved in the transaction between the customer and the provider of the good or service. Sometimes referred to as ‘indirect effects’, these costs are typically unrelated to the objectives of public risk regulation. Examples include the additional costs incurred in education and training sectors, arising from requirements to employ minimum numbers of qualified staff; and indirect financial impacts on other levels of government, where quality regulation diverts clients into other, higher cost government services.

1.3 Key issues to considerIn assessing costs and benefits for the purposes of undertaking a CBA, the following issues should be taken into account:

Include direct and indirect costs and benefits. Direct impacts are those clearly related to the purpose of the proposed regulation, while indirect impacts are incidental to the main purpose, although they may be of significant magnitude, and should therefore be taken into account in the CBA. For example, the direct benefits of occupational health and safety legislation can be measured in terms of the reduction in the costs of injuries and damage to production equipment. However, there will also be indirect benefits in terms of a reduction in industrial disputes, and improved productivity (because of fewer disruptions and a ‘healthier’ workforce).Where possible, the estimates of costs should also try and recognise deadweight losses that can result from changes to resource allocation that arise due to government intervention.


Be aware of transfers and avoid double counting. When assessing costs and benefits, it is important to identify those that are purely transfers (or redistribution) from one group of the community to another, and those which do not lead to an overall increase or decrease in costs/benefits when considered from the viewpoint of society as a whole. A transfer is a payment of money for which no good or service is received in return. Typical examples of transfers are welfare payments, which represent a cost to governments but a benefit to the recipients, and, in the other direction, taxes. (Regulatory fees are not transfers because regulatory services are received in return for the fees.) While the costs and benefits to the different parties should be identified in the CBA, care should be taken that they are not included in the overall net impact.

A similar issue relates to the double-counting of costs and benefits, which can often occur due to a failure to recognise the redistributive impacts of particular measures. For example, if firms’ costs increase as a result of the measure, they may pass this increase onto consumers in the form of higher prices. While it is important to identify both impacts in the CBA, the effect must not be double-counted in the overall assessment of costs.

Assumed effectiveness of regulations. An additional variable in determining the costs and benefits of a proposed regulation is the assumption made as to the effectiveness of the regulation in achieving the defined objective. It is rarely, if ever, possible to completely eliminate the identified problem (e.g. because of uncertainty as to scientific or technical variables, or because of compliance issues). Hence, risk-based regulatory approaches are encouraged wherever feasible, as a means of ensuring regulatory resources and effort are directed at areas assessed as greatest risk. In undertaking a CBA a realistic assessment is required as to what is likely to be achieved. The nature of this assumption will have a major impact on the benefits and costs attributed to the proposal. (In particular, there will be an interdependent relationship between the assumptions made regarding enforcement effort and the associated costs of enforcement).

Risk assessmentA cost-benefit analysis should contain an assessment of risk to assist decision-makers in their choice between different options.

Any problem identified as potentially requiring government intervention will have an element of risk attached to it. Risk refers to the probability that existing hazards will cause harm, i.e. that an undesirable event will occur. For example, measures to address occupational health and safety issues recognise that there is risk of an accident happening in the workplace. Risk analysis is the process of discovering what risk is associated with a particular hazard, which involves identifying hazards and the mechanisms that cause them, and estimating the probability that they will occur and their consequences.

Risk analysis is a valuable tool in addressing the threshold issue of whether or not governments should intervene. It helps to determine:

whether the risks that government intervention is intended to address are of significant magnitude compared with other risks; and

the extent to which government intervention reduces the initial risk problem.

Efforts at reducing risks are best directed to areas where gains are greatest and the risks are regarded as unacceptable (e.g. regulation of major hazard facilities), rather than cases where efforts will generate only modest gains.


Risk assessment enables decisions to be made about government regulation to ensure it is in proportion to the risks involved. The objective of implementing a proposal to deal with risk should not be to reduce the risk at all costs, or to reduce it to a minimum level, but rather to balance the marginal benefits and costs to society of lowering the risk. This might for example, include the use of risk assessment data to target regulatory requirements within a regulated sector according to classes of risk.

Issues to be addressed in the risk assessment include:

an appraisal of the current level of risk (i.e. before the introduction of the proposed measure);

the expected reduction in risk that would result from the introduction of the proposal; and consideration of whether the proposed approach is the most effective way to deal with the

risk.

1.4 Decision criteriaIn order to identify the preferred approach to addressing a problem or issue, the alternative options need to be compared using a clear and consistent decision framework.

Techniques for quantifying costs and benefitsTo compare the costs and benefits of different proposals, a standard unit of measurement is required. Thus, wherever possible, impacts are valued in dollar terms, using market data. This allows disparate costs and benefits to be aggregated so that an estimate can be derived of the net impact of a proposal on the community.

Valuing time

One important quantifiable impact common to regulatory proposals involves time spent in meeting compliance requirements by businesses (i.e. labour costs, including on-costs and overheads) and individuals in a non-work capacity (i.e. lost leisure time). To assist agencies in this exercise, an automated cost calculator is available at www.dtf.vic.gov.au. In order to estimate annual labour/leisure costs for inputting to a CBA, the automated cost calculator requires estimates of annual time impacts by (three broad categories of) workers and individuals in a non-economic capacity.

Valuing intangible impacts

In many cases, it is not easy to assign valuations to potential costs and benefits – particularly where such impacts are intangible. However, there are other techniques available to elicit values that can be used in cost-benefit analysis.

One method of valuation is to simulate the market by estimating the ‘willingness to pay’ or ‘willingness to accept’ a project’s outputs or outcomes. Willingness to pay for a little more of a service is a reflection of the value placed by consumers on an increment of that service. Since the amount that consumers are willing to pay depends to a large extent on income levels, valuations are usually obtained by averaging across income groups.

The quantification of potential social, health or environmental impacts normally requires an alternative approach to valuation. Techniques to establish money values for this type of non-market impact generally involve the inference of a price, through either a revealed preference or stated preference approach. Revealed preference techniques involve inferring an implicit price revealed indirectly by examining consumers’ behaviour in a similar or related market. Hedonic pricing is an example of this approach, and is used in the valuation of environmental impacts. For example, the relationship between house prices and levels of


environmental amenity, such as peace and quiet, may be analysed in order to assign a monetary value to the environmental benefit. Stated preferences are normally obtained by specially constructed questionnaires and interviews designed to elicit estimates of the willingness to pay (WTP) for, or willingness to accept (WTA), a particular outcome. Examples include the contingent valuation method.

‘Methodologies for valuing environmental impacts’ section below summarises these and other methodologies that might be considered for valuing environmental impacts. Caution should be exercised in using these methodologies since some (particularly the stated preference/survey techniques) are still subject to academic debate and may present practical difficulties in their application. However, examples of instances where these other valuation approaches might be useful include:

measuring the costs of pollution at beaches by observing distances travelled to swim at clean beaches;

valuing the impact of the noise associated with living by a highway by comparing prices of homes near to the highway with those of similar sized properties in a quieter neighbourhood; and

measuring the value that drivers place on their time by observing how much they are willing to pay to use a toll road rather than using a slower freeway.

Methodologies for valuing environmental impacts

Market-based techniques

These are used where a direct quantitative link can be established between potential changes to the environment and activities that already have a market value. Approaches include: Productivity method – is useful where a change in the environment leads to a change in

production levels, costs or prices (e.g. water pollution may reduce crop yields). It examines the value of the change in outputs to provide for the change in environmental quality.

Human capital method – uses estimates of foregone earnings and the cost of illness to value environmental goods. Typically used when a change in the environment leads to impacts on health and labour productivity (e.g. cost of health impacts from air pollution).

Replacement cost, repair cost and substitute cost methods – estimated values based on either the cost of replacing environmental assets, or the cost of providing substitute services. An example is the value engineering works used to prevent soil erosions after land clearing.

Defensive expenditures/damaged cost avoided method – may be used where actions are undertaken to prevent the effects of a change in environmental quality (e.g. householders installing noise insulation following construction of a major road to mitigate noise impacts).

Revealed preference techniques

These estimate the value of an environmental good or service by examining the process for a closely associated (‘surrogate’) good that is traded in the market. Approaches include:

Proxy good method – uses the value of a close market substitute to value an environmental good (e.g. bottled water being purchased as a substitute for tap water).

Travel cost method – assumes the value of an environmental asset (e.g. a recreational site) is reflected in how much people are willing to pay to travel to visit the site. This, in turn, is calculated by the cost of travel.

Hedonic pricing – estimates costs on the basis of how the market price of another good is affected. Typically, this is applied to variations in housing prices that reflect the value of local environmental attributes.


Stated preference/survey techniques

These use a survey to create a hypothetical market for the environmental good or service being valued. Approaches include:

Contingent valuation method – asks people to state directly their willingness to pay for specific environmental services, through a survey methodology based on a hypothetical scenario; and

Contingent choice method – is similar to the above method, but is based on asking people to make trade-offs among different sets of environmental attributes. It does not directly ask for willingness to pay – instead, it provides information on the relative importance of different attributes. If some of these attributes are monetary, the results can be used to derive the relative value of non-monetary attributes.

Once proposals have been ranked according to their economic or allocative effects, the cost-benefit analysis should also explicitly assess each proposal’s distributional effects. Legislative Impact Assessments, for example, require an explicit assessment of the impact on small business (as compared to large businesses). Other reference groups will vary according to the particular issue being addressed and might include: regional and urban areas; rich and poor; different ethnic groups; different age groups; those living near a hazard versus those living a large distance away from it.

Allowing for uncertaintyThe precise value of future costs and benefits is uncertain. In undertaking a cost-benefit analysis, there may be a range of reasonable assumptions that could be used, and individual judgements may vary about what constitutes ‘best estimates’. To provide decision-makers with adequate information relating to the margin of error surrounding single-point estimates of net present value (NPV), it is useful to provide a range of results about possible impacts.

This can be achieved by using ‘sensitivity analysis’, which can help to account for differences in judgement, or uncertainty, and the impacts that they have on the outcomes of cost/benefit assessments. Sensitivity analysis involves altering some of the critical assumptions and recalculating the estimated NPVs with different assumptions – for example, ‘best case, ‘base case’ (most likely) and ‘worst case’ scenarios.

It is important that risk and discounting be treated separately. Some analysts use a higher discount rate than they would use in the absence of risk. However, this can result in an incorrect estimate of the NPV for regulatory proposals. For example, if there is a large expected cost in the late years of a proposal, a higher discount rate (to account for risk) will reduce rather than magnify this cost.

Accounting for timing of impactsWhere impacts occur over time, the value of costs and benefits are ‘discounted’ (as discussed below) to ensure that they are assessed in constant dollar terms. The tool for undertaking this is net present value (NPV). In the case of NPV, the basic decision criterion is that NPV must exceed zero (i.e. total benefits exceed total costs, so that there is a net benefit). However, there may be circumstances in which it is appropriate to set a higher NPV requirement as the criterion that determines the attractiveness of an option. This might be the case, for example, where there is a high degree of uncertainty as to the size and/or timing of the benefits of the proposal.

When undertaking a NPV, a discount rate needs to be applied to costs and benefits arising over the duration of the proposal. The need to discount reflects the proposition that in general, society is not indifferent with respect to the timing of costs and benefits – typically, people prefer to receive benefits as early as possible and pay for costs as late as possible. In other


words, the value of a dollar received today is more than the value of a dollar received some time in the future. To take this time preference into account, the stream of future costs and benefits is discounted using an interest rate (known as the ‘discount rate’). Discounting allows impacts to be valued in today’s dollars, which, in turn, can be used to compare the costs and benefits of different options on a consistent basis. The higher the discount rate, the greater the erosion effect on future costs and benefits. A low discount rate, on the other hand, preserves future values to a greater degree.

There is much literature on the ‘correct’ discount rate to use when weighing up costs and benefits of government-imposed regulation that accrue over time. Having decided on a discount rate, it is important for it to be used consistently across all regulatory proposals. This allows the total costs and benefits of different proposals to be compared, and assists in the prioritisation of regulatory action.

The Department of Treasury and Finance has published Economic Evaluation for Business Cases Technical Guidelines [available at www.dtf.vic.gov.au] for use by departments in considering investments. The guidelines identify three categories of investments, each with a recommended discount rate. When undertaking a NPV for a regulatory proposal a real discount rate of 4 per cent should be used. This is the assigned discount rate for Category 1 projects in the Guidelines, which relate to core public sector infrastructure for which benefits are not easily quantified (and which are considered most analogous to government regulation). Where a department feels that specific circumstances of a proposal warrant a different real discount rate, the LIA or RIS should clearly articulate reasons for selection of the alternative rate.

The benefit-to-cost ratio is calculated by dividing the present value (i.e. discounted) benefits of an option by the present value of its costs. Clearly, in order to generate a net benefit, the criterion must be that the ratio would exceed one. The benefit-to-cost ratio provides a useful indication of the riskiness of the option. Because the rule is influenced by the ratio of benefits to cost, measures that rate well against the benefit to cost rule are those that are likely to be least affected by unexpected increases in costs or decreases in benefits.


2. Enhancing decision-making in the absence of a full cost-benefit analysis

A full cost-benefit analysis (CBA) represents best practice in evaluating the impact of viable policy options as it gives decision-makers a strong basis for comparing policy alternatives on the basis of quantifiable (monetary) costs and benefits. As such, a fully quantified CBA should be undertaken for high-impact LIAs and RISs (see Step 4 of Chapter 2 of the VGR).

Qualitative information can enhance decision-making, but also has the potential, if not presented in a clear and objective manner, to be interpreted differently by various stakeholders.2 In such instances, a multi-criteria analysis (discussed further below) may be useful in integrating quantitative and/or qualitative information in a way that allows options to be compared on a more transparent and consistent basis.

Where the costs or benefits of the policy options being considered cannot be sufficiently or confidently quantified and monetised, supplementary decision-making tools to assist in comparing or ranking options include:

break-even analysis; cost-effectiveness analysis; and

multi-criteria analysis.

Break even analysisWhen to use: Break even analysis (BEA) can be used where a monetary estimate of units of benefits is possible, but the effectiveness of a policy option or the magnitude of the likely benefits is uncertain. For example, regulating tobacco consumption through health warnings can be expected to reduce tobacco related deaths and health costs, but it may be unclear as to how effective this policy option will be in directly realising such outcomes (for example where such a policy has not been implemented elsewhere). Break-even analysis can also be used to supplement a multi-criteria analysis (see below) to see whether the benefits of the preferred option are likely to exceed the costs.

How to use: BEA can be used by estimating the required benefits of an option needed to offset its estimated costs. In conducting a BEA, policy-makers make judgements regarding the degree to which a policy option could be expected to deliver such benefits. These judgements should be based on practical experiences with similar policy proposals (e.g. in other jurisdictions) or other objective data. This technique involves dividing the costs of the option by the monetised value of a ‘unit’ of benefit in order to identify the minimum amount (or units) of benefits required to be achieved for the option to break-even. By estimating the minimum benefits required, this approach allows a judgement to be made about the likelihood of those benefits actually being achieved.

2 OECD (2008) Introductory Handbook for Undertaking Regulatory Impact Analysis (RIA), October, p.9-10, accessible at www.oecd.org


http://www.oecd.org/

Example:

A hypothetical proposal is expected to improve safety by reducing fatalities and preventing injuries and the cost of the proposal can be estimated with reasonable certainty. While there are widely used estimates of the value of a statistical life (VSL) (assumed here to be $4 million) and the value of avoided injuries, in terms of hospitalisation costs and lost productivity (assumed here to be $250 000 per injury), there may be no way of confidently and accurately quantifying how many lives will be saved and injuries will be avoided from the proposal.

It is possible to use this available information to determine how many fatalities/injuries would need to be avoided in order to justify the costs of the proposal, that is for the proposal to ‘break-even’. Various combinations of fatalities and injuries prevented would see the proposal break even. For example, if the total cost of implementing and complying with the proposal is $13 million per annum, the proposal would need to prevent three fatalities and four injuries each year to break-even, using a VSL of $4 million and the cost of injuries of $250 000. Similarly, preventing 2 fatalities and 20 injuries would also allow the proposal to break even.

Judgment needs to be exercised to determine whether such a proposal would achieve the magnitude of benefits required to break-even given the nature and size of policy problem (e.g. does the proposal target a small element of the problem?) and the expected practical effect of the proposal (e.g. what is the intervention logic and what behaviours/activities are expected to change?). In this example, if the current level of fatalities is 2 and the current level of injuries is 3, then the break-even won't be achieved. If the current level of fatalities is, instead, 30 and of injuries is 100, then it is more likely to be achieved (as the required break-even points represent about 10 and 4 per cent respectively of the current level). In the latter case, the judgment as to whether the break-even point is feasible should be supported by objective data, for example based on historical time-series incident data and the counterfactual/baseline, overseas experience, the safety-related outcomes experienced from a similar policy proposal, or academic research.

Limitations: BEA is a useful tool for analysing policy options but less useful for comparing the relative effectiveness of several options. For example, two $13 million policy proposals will have the same break-even point in terms of benefits they need to achieve with the methodology providing no guidance on which one is likely to deliver greater benefits.

Cost-effectiveness analysisWhen to use: Cost-effectiveness analysis (CEA) is useful technique to use when it is difficult to assign dollar values to benefits, but where dollar cost estimates are more readily available. In such cases, benefits may be expressed in terms of physical units (e.g. the number of lives saved, the number of accidents prevented), while costs are expressed in dollar terms. Cost effectiveness offers a priority ranking of options on the basis of comparative ‘cost per unit of effectiveness’ or, expressed in a different way, ‘units of effectiveness per dollar’. It is applied where the options are equally effective (i.e. they produce the same outcome).

Cost-effectiveness analysis is useful in cases where it is easier to identify benefits than it is to assign a dollar value to them. As such, it can play an important role in evaluating proposals that have impacts in areas of social policy such as health, safety and education. For example, the assessment of health proposals are commonly expressed in terms of non-monetary units, such as quality adjusted life years (QALYs), disability adjusted years, changes in life expectancy or the number of post-operative infections. Alternatively environmental proposals can be assessed on ‘changes in emissions of a pollutant’, ‘numbers of native species protected’.


How to use: CEA divides the cost of an option by the units of benefits expected to be achieved under that option (i.e. the specified policy outcome), with the best option selected on the basis of delivering the lowest cost per unit of benefit.

Example:

Two policy options are aimed at reducing the emission of a certain type of pollutant. Option A costs $500 000 and reduces emissions by 10 per cent, while Option B costs $300 000 and will reduce emissions by five per cent.

Option A BCost $500 000 $300 000Reduction in emissions (per cent) 10 5Cost for each per cent reduction in emissions achieved

$50 000 $60 000

Although Option A has the highest cost, under CEA it has a lower unit cost (or cost per reduction in emissions achieved) than Option B and would be considered the preferred option.

Limitations: A limitation of CEA is that it does not address the basic policy question of whether the defined policy objective should be pursued in terms of the benefits exceeding the costs – only which of the options under consideration is capable of delivering the objective most cost effectively.

Multi-criteria analysisWhen to use: Multi criteria analysis (MCA) can be used when it may not be feasible to quantify all of the impacts of an option (i.e. such as where there are no, or excessively complex, robust techniques that would enable the effects of the proposal to be monetised).

How to use: MCA or ‘balanced scorecard’ approach requires judgements about how proposed options will contribute to a series of criteria that are chosen to reflect the benefits and costs associated with the proposals. The criteria should be consistent with the stated policy objectives for the proposal and weighted according to their relative importance to the final decision.

A qualitative score would be assigned, depending on the impact of the option on each of the criteria measured relative to the base case. A criterion rating scale from -10 to 10 is preferred as it is easier to include more information on the choices made, and this results in a greater understanding of the proposal. For instance, a score of 10 would indicate that the option has twice the impact of an option with a score of 5 (and five times the impact of an option with a score of 2 etc.). For example, if one option incurred costs of $3.5 million per year, and another option $7 million, then the former option might receive a rating of –5, while the latter would score –10.

In order to maximise the effectiveness of MCA as a decision tool, it is critical that the choice of criteria and individual weightings assigned are developed in a robust manner and clearly identified and explained (for example, based on linkages to overriding policy objectives).


To be effective, an MCA, should meet the following standards:

1. Appropriate weights to be assigned for cost and benefit criteria. The weights assigned can have a significant effect on outcomes. A high weighting

on benefit-related criteria relative to the cost criteria biases the outcomes:– against options that have relatively low costs (the variable about which the

evidence tends to be more robust); and– towards options that rate highly on the benefits-related criteria (which tend to

be measured on a more subjective basis). In light of this, neutral weights of 50 per cent for cost-related criteria and 50 per

cent for benefit-related criteria must be applied, unless appropriate alternative weights can be justified.

2. The scoring scale to be used. A symmetric scale ranging from -10 to +10 is simple to apply and understand, as

well as allowing enough scope for differences across options to be distinguished. This range must be used in all RISs and BIAs that use MCA as a decision tool.

3. A broad indication of appropriate/inappropriate criteria. The criteria for the MCA must link closely to the identified problem/s and

objectives. Cost criteria should be defined as ‘cost’ not ‘cost minimisation’. This specification

of the criterion allows the costs to be assessed appropriately relative to the base case (i.e. an option that is more costly than the base case will receive a negative score).

Criteria must be specified in a way that avoids overlap between them.

4. The nature of the discussion that must be included in a RIS/BIA to support the MCA. The reasons for including the selected criteria (and how they are defined) must be

clearly outlined in the RIS/BIA.

The rationale for the weights assigned to each criterion must be clearly explained/justified.

The scores assigned for each option against each criterion must be justified and be evidence-based (with the extent and nature of the evidence required to support the analysis dependent on the magnitude of the impact of the proposal).

The relative scores assigned to each option for each criterion must be consistent with the relative effects in relation to each criterion (e.g. if one option would lead to costs being $10 million higher than in the base case, while another option would lead to costs being $1 million higher, it would generally be appropriate to assign scores of -–10 to the first and -1 to the second option, but assigning scores of -10 and -9 respectively would not be appropriate).

Where the weighted total scores for some options are especially close (and, therefore, the results of the MCA are sensitive to the chosen weightings), this must be explicitly noted in the RIS/BIA, including in the executive summary.

Where a policy option imposes a compliance cost on business (i.e. is assigned a negative weighted score), the impact analysis should at least estimate the magnitude of compliance costs being proposed.


Example

To achieve a reduction in road related accidents, two options may be considered and evaluated based on the following simplified multi criteria analysis, with the assignment of scores ranging from –-10 for negative outcomes to +10 for positive outcomes. (Outcomes that maintain the status quo would receive a score of zero.)

Option 1 Option 2

CriteriaWeighting

(%)Assigned

scoreWeighted

scoreAssigned

scoreWeighted

scoreReduction in road-related accidents

40 +10 +4 +5 +2

Costs of compliance and administration

50 -5 -2.5 -3 -1.5

Improved traffic flow 10 0 0 -10 - 1Total 100 +1.5 -0.5

The assigned scores indicate that Option 1 is considered to reduce road related accidents by twice as much as Option 2. Meanwhile, the compliance and administrative costs of Option 1 are higher than for Option 2. Option 1 has no expected impact on traffic flow.

In this example, Option 1 is the preferred approach because it yields a positive score (of +1.5). Option 2, on the other hand, returns a negative result (-0.5) and would therefore be considered to be an undesirable proposal.

When presenting the results of MCA in BIAs and RISs, it is important to provide sufficient commentary to explain the approach, particularly in terms of providing justification for the choice of criteria, the weightings of the criteria, and the scores assigned to the different options for each of the criterion. A brief explanation of the role of MCA is also useful – particularly in RISs, where the reader may be unfamiliar with this type of analysis.

Limitations: While a useful policy tool, care should be taken that MCA is not used as an alternative to more rigorous, quantitative analysis of benefits and/or costs, where this is feasible.


Attachment 1. Competition test assessment

Stage 1: Identify the restriction on competitionAll proposals for legislation must be examined to identify restrictions on competition contained within any of their provisions. This includes legislation that:

allows only one participant to supply a good or service (i.e. a monopoly);

requires producers to sell to a single participant (i.e. a monopsony); limits the number of producers of goods and services to less than four (e.g. duopoly or

oligopoly); limits the output of an industry or individual producers;

discourages entry by new persons into an occupation or prompts exit by existing providers; imposes restrictions on firms entering or exiting a market (e.g. through a licensing or

accreditation scheme); introduces controls that reduce the number of participants in a market (e.g. because cost

imposts are large enough to result in a significant contraction in the number of businesses); affects the ability of businesses to innovate, adopt new technology, or respond to the

changing demands of consumers; imposes higher costs on a particular class of business or type of products or services (e.g.

flat rate fees impose a proportionally higher burden on small business); locks consumers into particular service providers, or makes it more difficult for them to

move between service providers; and/or imposes restrictions that reduce the range or price or service quality of options that are

provided in the marketplace.

A potential restriction may also be identified by considering whether there will be changes to the way a market functions as a result of the implementation of the proposed legislation. Further guidance for identifying restrictions on competition is provided in below which summarises work undertaken by the Secretariat of the Organisation for Economic Cooperation and Development’s (OECD) Working Party No. 2 on Competition and Regulation in relation to incorporating competition assessment in the analysis of regulatory proposals.


Further guidance for identifying restrictions on competition1. Limit the number or range of suppliers – for example, if the proposed measure:

grants exclusive rights for a supplier to provide a good or service;

establishes a licence, permit of authorisation process as a requirement of operation; limits the ability of some types of suppliers to compete;

significantly raises the cost of entry or exit by a supplier; or creates a geographic barrier to the ability of companies to supply goods or services,

invest capital or supply labour.

Potential justification Potential anti-competitive impacts Encourage investment Consumer protection objectives Instrument of regional or industry

policy

Market power created and competitive rivalry reduced

Reduced price competition Reduced innovation and lower incentives to

meet consumer demand (lower quality)

2. Limit the ability of suppliers to compete – for example, if the proposed measure:

controls or substantially influences the price at which a good or service is sold; limits freedom of suppliers to advertise or market their goods or services;

sets standards for product quality that provide an advantage to some suppliers over others or that are above the level that many well-informed customers would choose; or

significantly raises costs of production for some suppliers relative to others (especially by treating incumbents differently from new entrants).

Potential justification Potential anti-competitive impacts Protect small producers from ‘unfair’

competition Consumer protection objectives

Can reduce the intensity and dimensions of rivalry

Higher prices for consumers Less product variety

3. Reduce the incentive of suppliers to compete vigorously – for example, if the proposed measure:

creates a self-regulatory or co-regulatory regime;

requires or encourages information on company outputs, prices, sales or costs to be published;

exempts the activity of a particular industry or group of companies from the operation of general competition law; or

reduces mobility of customers between suppliers of goods or services by increasing the explicit or implicit costs of changing suppliers.

Potential justification Potential anti-competitive impacts Ensure technical standards are

appropriate and advance with technology Improve consumer information and

efficiency of markets

May encourage cartel-like behaviour, restricting output and raising prices

Source: Based on work undertaken by OECD Working Party No. 2 on Competition and Regulation, October 2006.


Stage 2: Show that the restriction is necessary to achieve the objectiveIf Stage 1 suggests that a proposed legislative option will restrict competition in some way, then a second stage of analysis is required to demonstrate that the objective of the proposed measure can only be achieved by restricting competition. Thus, in this stage, it is necessary to:

articulate the objective that is to be achieved by restricting competition in the context of the proposed legislation; and

assess all practicable means of achieving the objective, including non-legislative means, rather than by the restriction on competition.

This stage is important because it requires demonstration of a specific and unique link between a desired objective and the restriction. A vaguely asserted link, or an objective that could be achieved by means other than restricting competition (e.g. by introducing more competition, amending other legislation to remove the need to restrict competition, or altering market structures) will not be sufficient.

Stage 3: Assess whether the benefits of the restriction outweigh the costsThe final stage of the analysis is to demonstrate that the benefits to the community of the restriction to competition outweigh the costs. This will clearly draw upon the cost-benefit analysis undertaken in Step 4 of the LIA or RIS, focusing on those costs and benefits that are linked directly to the restriction on competition (i.e. any impacts that are expected to result from any other aspects of a proposal should not be included in the competition test assessment). As with the cost-benefit analysis in Step 4, the results of this assessment must be presented in quantitative and monetary terms as far as is possible.


· web viewvictorian guide to regulation updated july 2014, toolkit 2: cost-benefit analysis i 2...

Documents