Evaluating Investments CBA or CGE? Evaluating Investments CBA or - - PowerPoint PPT Presentation

Evaluating Investments – CBA or CGE? Evaluating Investments CBA or CGE?

Peter Forsyth Peter Forsyth Monash University NZ Treasury Seminar easu y Se a September 6 2011

1

Problem Problem

• CGE models are now used often to

assess whether investments are assess whether investments are worthwhile The traditional technique is to use CBA

• The traditional technique is to use CBA
• But which should be used?
• Which is correct?

2

• Both

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Argument Argument

• Properly specified, both should give the

same answer – i e no inconsistency same answer – i.e. no inconsistency

• But there are limitations with both

techniques techniques

• But these are complementary
• Possible to use both to improve

investment evaluation

• (If that is what decision makers want)

4

Theme Theme

• Recognising the different roles of the

two two

• Use the two to improve evaluation
• Reconciling the two obtain consistent

results

5

Agenda Agenda

• Use of CGE in project and policy

evaluation evaluation

• Characteristics of CBA and CGE

f

• Issues for analysis
• Integrating CGE and CBA- is there

convergence?

• Conclusions

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Use of CGE in Project Evaluation Use of CGE in Project Evaluation

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Literature Survey Literature Survey

• Growing recognition that CBA and CGE are on

about the same things g

• Use of CGE to inform CBA (key shadow prices

etc)

• Critical discussion eg BTE 1999
• Texts eg Boardman et al 4 edn p124

g p

• Recognition of the issue (eg Layman)
• But no integrated or comprehensive discussion

g p

• We’re confused!

8

CGE as a Project Evaluation Technique CGE as a Project Evaluation Technique

• CGE models are now used quite often as a way
• f evaluating investments

g

• Esp for large infrastructure projects
• Melbourne CityLink, East West Transport Study

Melbourne CityLink, East West Transport Study (Eddington)

• Also, non infrastructure investments (Sydney

( y y Olympic Games 2000)

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The Tandem Approach- Pedalling in Different Directions?

• Often done alongside a CBA

CityLink East West study Melbourne

• CityLink, East West study, Melbourne

Grand Prix ff f

• Two different assessments of the same

project

• How comparable are they?
• They may be close (identical), but not

y y ( ), couched in the same terms

10

What’s Missing? What s Missing?

• A common welfare measure e.g.
• Melbourne East West

Melbourne East West

• CBA – Net Benefits

$1.0bn

• CGE

(in 2031) $852bn GSP

• CGE

(in 2031) $852bn GSP

• A good or bad project - what does this mean?
• A good or bad project - what does this mean?
• Results are not comparable
• But this can be resolved we can get
• But this can be resolved -we can get

comparable welfare measures for both

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On the Same Track On the Same Track

• CGE and CBA can address the same evaluation problems
• How much better off is the economy as a result of this

project or policy?

• Both have limitations and rely on approximations
• “Once the additional used to increase production and
• “Once the additional used to increase production and

consumption are allowed for, CGE model results and CBA are speaking the same language. CGE modelling lt th b d t h th lt f CBA results can then be used to enhance the results of CBAs, rather than to be used as an alternative” Layman, 2004 (?)

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Characteristics of the Techniques Characteristics of the Techniques

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Relative Characteristics of CBA and CGE Relative Characteristics of CBA and CGE

• CBA can measure all costs and benefits of a project
• CGE constrained by the model, usually at a high level of

aggregation

• But details can be handled with sub models
• Many effects are location specific eg noise congestion
• Many effects are location specific, eg noise, congestion –

difficult to handle in CGE

• Externalities difficult to handle with CGE (Not always)
• CBA is usually used as a partial equilibrium approach

(Not always)

• CBA tends to have difficulty with macro effects (eg
• CBA tends to have difficulty with macro effects (eg

stimulation of a state econ)

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Con’t Con t

• Difficult to handle distributional effects and measure

incidence of changes in CBA

• Upshot- take advantage of complementarities

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Caution Caution

• CBA and CGE are two approaches which are soundly

based in theory

• Other alternatives are not
• Eg using Input/Output Impact analysis
• Guaranteed to produce very big “Benefits”
• Guaranteed to produce very big “Benefits”
• Increasingly used to “sell” projects (Dwyer et al 2004)

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CGE and IO CGE and IO

• CGE an outgrowth of IO
• CGE to answer the limitations of IO

Should IO ever be used? I i b f t i t ( h t t

• In measuring – eg carbon footprint (a snapshot- not

estimation of impact)

• In some regional analysis

g y

• When full CGE not available

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Issues Issues

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Issues Issues

• Measuring welfare
• Disaggregation and detail
• CBA and PE
• Externalities

U l t

• Unemployment
• Macro effects
• Wider economic benefits (Transport)

Wider economic benefits (Transport)

• Measuring key shadow prices
• Misusing CGE
• Data limitations and use of proxies

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Welfare Measures Welfare Measures

• Theory of welfare measurement for CBA well established
• Many CGE users are very cavalier (this does not have to

be so) be so)

• Simply identify benefits with change in GDP,

consumption

• Are inputs to production free, as many implicitly argue?
• Many CGE models have no explicit welfare criterion

B t d t i htf d t i t

• But some do – straightforward to incorporate

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Proxy Measures? Proxy Measures?

• GDP is a welfare measure -
• But under extremely restricted assumptions
• Generally a bad measure
• Can develop acceptable proxy measures, allowing for

costs of factor inputs costs of factor inputs

• GNI (allowing for terms of trade effects), adjusted for cost
• f additional capital and labour
• Suitable for marginal changes
• “Avoiding the Manna from Heaven assumption” (Dixon)

C t fit d l hi h d t h li it

• Can retro-fit a model which does not have an explicit

welfare measure

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Rigorous Measures Rigorous Measures

• Theory of welfare measure measurement is well

developed

• Consumers and producers surplus – properties well

known

• Multi product measures can be used (eg King equivalent

Multi product measures can be used (eg King, equivalent gain)

• Require info available in a CGE model (eg demand

t ) system)

• Can handle non marginal changes
• Welfare measure can be as rigorous or casual as in CBA

Welfare measure can be as rigorous or casual as in CBA

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Measuring Welfare Measuring Welfare…

• Essential if CGE and CBA results are to be compared and

differences can be reconciled

• Fundamentally not a difficult exercise
• Theoretical basis is the same

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An Aside An Aside…

• This is true for all policy evaluations using CGE
• Do need to have the correct welfare measures
• (Often not the case in Australia, even though Australia

relies heavily on CGE)

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Disaggregation and Detail Disaggregation and Detail

• CGE models are often at a high level of aggregation
• Though not necessarily – detail can be brought in
• Can expand the model to bring in the necessary detail
• Eg, the model may have a “rail” sector- bet we can break

it down to “rail and a “HST” sector it down to rail and a HST sector

• And, indiv HSTs
• Eg, develop a tourism specific model based on MMRF

g Green (A state based model with a CO2 component)

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CBA and Partial Equilibrium CBA and Partial Equilibrium

• Most CBA studies are primarily PE
• Little detail except for big distortions
• Need not be
• Ideally, CBA is a GE technique, capable of shedding light
• n indirect effects
• n indirect effects
• GE theory for CBA- Dreze and Stern, Dinwiddy and Teal
• But you need a way of measuring the GE effects

y y g

• I.e . a CGE model
• Some GE impacts are potentially large

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Externalities Externalities

• In markets are not included in a CGE model, impacts will

not be measured

• But externalities will be left out – noise will not be

measured

• Can adjust for this- measure and add in the cost of noise

Can adjust for this- measure and add in the cost of noise, just as for CBA

• Don't need to include in the model-can retro fit

27

Incorporate Externalities? Incorporate Externalities?

• Can include select externalities in a model
• Eg, including CO2 in MMRF Green
• Can then estimate the net effects on CO2 of a project,

allowing for indirect effects

• Eg the effects on CO2 of a HST
• Eg the effects on CO2 of a HST
• Direct effects easy to measure
• But not the indirect effects
• Could even be negative
• Easy to assess using a CGE model

28

Unemployment Unemployment

• Suppose there is less than full emp
• What is the shadow wage, and impact on unemployment?
• Very difficult to answer using a PE framework
• Also difficult using some CGE models, which have simple

labour supply assumptions labour supply assumptions

• The biggest practical problem in CBA?
• Potentially large impact on measurement of project

y g p p j benefits

• Can at least put limits on the problem using a CGE model

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Macro Effects Macro Effects

• Often not well handled using CBA
• Yet macro effects are sometimes big, esp when state

economies are considered (factors can move interstate)

• The benefits from a road could include stimulating the

econ econ

• What is the benefit to Victoria from an $1bn in tourism or

econ activity?

• (Benefits of tourism are the sum of lots of small gains

and losses which add up to significant effects)

• The gains and losses can be measured using a CGE

The gains and losses can be measured using a CGE model

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Wider Economic Benefits (of Transport) Wider Economic Benefits (of Transport)

• Given prominence in EU, East West Study (Mel)
• Two sources:
• Agglomeration effects
• Tax distortions

C th b h dl d?

• Can these be handled?

31

Can Effects be Measured With a CGE Model?

• Agglomeration effects- not really, unless you have a very

detailed model (not available) (econometric approaches f l) useful)

• Tax distortions- easy, if you have a model which models

the tax structure accurately

• Which some do
• Conventional measures of the value of time do not

th i t lf f i i ti measure the impact on welfare of a saving in time correctly (do consumers always use all of their time savings in extra leisure? Forsyth)

• The products of projects can be taxed or subsidised, and

this should be accounted for

32

Shadow Prices Shadow Prices

• A simple way of using a CGE model – show light on key

shadow prices

• Marginal welfare cost of tax, exchange rate, shadow

wage, price of fuel

• Eg estimates of MWC of tax (Stuart) – bigger than PE

Eg estimates of MWC of tax (Stuart) bigger than PE measures

• Canadian shadow exchange rate (Jenkins and Kuo)
• Can’t be done using Monash/ MMRF – fixed labour supply

33

Data Availability Data Availability

• Both approaches need a lot of data

Esp CGE

• Esp CGE
• Need to have a complete model of the

CG economy with CGE

• May use proxies and sensitivities

34

Large and Small Projects Large and Small Projects

• CBA and/is used for large and small projects
• What about CGE
• Some examples of use in large projects (Melbourne

Eddington study)

• Can in principle be used for small projects
• Can in principle be used for small projects
• If models are available, and model can pick up the

changes (not too aggregated)

• Simulations are not necessarily expensive

35

Misusing CGE Misusing CGE

• Easy to do
• Eg loading the assumptions to get a result

Eg, loading the assumptions to get a result

• Such as assuming very large impacts on

employment even if the labour market is tight employment even if the labour market is tight

• The result is that all projects look good and

there is a big impact on output and benefits g p p

• Using GDP/GNI as a welfare measure?
• Relevance for Australia at the moment?

36

Cost of CGE Models Cost of CGE Models

• Often claimed “CGE far too costly”
• Usually existing models can be used
• Model simulations are not expensive
• Many models to choose from in Australia

37

Ways Forward Ways Forward

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Ways Forward Ways Forward

• We can seek to integrate CBA and CGE
• They are complementary techniques

They are complementary techniques

• In theory, should give the same answer
• In practice both have limitations
• In practice, both have limitations
• Can use both to get a better evaluation of a

project project

39

Approaching the Answer from Two Directions

• Often two reference points are better than one
• Express using a common welfare measure (a

Express using a common welfare measure (a challenge for Australia)

• Work out impact on welfare using both ways

Work out impact on welfare using both ways

• Work out why they are different- develop a

concordance

• Assess the accuracy of the approaches

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Progress to Date/Priorities Progress to Date/Priorities

1. Welfare measures- should be easy 2. Getting the theory of how to measure right (will a CGE study pick this up?) 3. Do a study which brings CBA and CGE together 4 Develop a concordance why are they different and 4. Develop a concordance- why are they different and why?

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Conclusions Conclusions

• CGE now being used as an investment evaluation tool
• Poses the question of what relationship this has with

CBA

• Use so far has not been very illuminating
• Many attempts but there is no overall theory or guide
• Many attempts, but there is no overall theory or guide
• The two techniques are complementary
• But they do need to be used in a comparable way

y p y

• Clear potential for improvements in evaluation

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Thank You! Thank You!

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Refs Refs

M King J Pub Ecs 1983 P Dixon EP 2009 J Dreze and N Stern Handbook of Public Ecs J Dreze and N Stern, Handbook of Public Ecs C Dinwiddy and F Teal, CUP 1996 G Jenkins and Kuo CJE C Stuart, AER 1984 P Forsyth JTEP 1980 Abelson EP 2011 Abelson EP 2011 Bureau of Transport Economics 1999 Dwyer, Forsyth Spurr, TM, 2004 Boardman et al 2010 Eddington Melbourne East West Study 2008 Layman, 2004

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