1 Appointment, terms of reference and recommendations

1.1 Cost-benefit analysis of public measures

The resources available to society are scarce. Cost-benefit analysis1 is a tool for clarifying the consequences of public sector resource use. Such analysis may be applied to investments, regulatory changes and programmes; what we may collectively refer to as “public measures”. The main purpose of cost-benefit analysis is to clarify and highlight the consequences of alternative measures prior to deciding whether to implement such measures. Consequently, cost-benefit analysis is a way of systematically organising information (NOU 1998: 16 Green Paper). Such analysis shall form part of the basis for making decisions, without thereby amounting to a decision rule.

In Norway, the first guide within this area was drafted under the direction of the Ministry of Finance in 1978, under the name of “Programme Analysis”. New technical reports were prepared in 1990s by the “Cost Calculation Committee”, whose work resulted in the NOU 1997: 27 Green Paper; Cost-Benefit Analysis, and the NOU 1998: 16 Green Paper; Guidance on Using Profitability Assessments in the Public Sector. The guide to cost-benefit analysis by the Ministry of Finance was published in 2000 on the basis of such reports.

It is important that the framework is updated. The Ministry of Finance revised its guidelines on cost-benefit analysis in 2005. Key elements of such revision were modifications to the guidelines for determining the discount rate, presentation of more examples, as well as making the guide more pedagogic and user friendly. In order to further improve user friendliness, the Norwegian Government Agency for Financial Management published a cost-benefit analysis handbook in 2010. Technical developments have taken place nationally and internationally within the area of cost-benefit analysis since the revision in 2005. The Government appointed, against this background, an expert committee to review certain aspects of the public sector cost-benefit analysis framework anew. Key themes of such review are social effects that change during the analysis period and that are realised in the distant future, and uncertainty in such regard. The present NOU Green Paper is a supplement to the NOU 1997: 27 Green Paper and the NOU 1998: 16 Green Paper. Information in the present Report is up to date as per 1 September 2012.

1.2 Terms of reference

On 18 February 2011, the Government appointed an expert committee to review the cost-benefit analysis framework. The terms of reference of the Committee were worded as follows:

Technical developments have taken place nationally and internationally within the area of cost-benefit analysis since the Ministry of Finance published its cost-benefit analysis guide in 2000, and subsequently revised it in 2005. The Stern Review placed a special focus on social effects in the distant future. Similar and other types of issues have been noted by Norwegian academics. An expert committee is appointed for these reasons, to review the cost-benefit analysis framework, and to consider the potential expansion and specification of the cost-benefit analysis guidelines.

The Expert Committee shall review technical developments within cost-benefit analysis since the establishment of the framework in 2000, and shall examine relevant issues on such basis. Issues it will be appropriate for the Committee to address will be discussed in the following.

The cost-benefit analysis guide of the Ministry of Finance does not explicitly address the fact that analysis parameters may change over time, for example that the value of time and time savings may be assumed to increase in line with real wage growth in the economy. Correspondingly, the willingness to pay for environmental goods may change over time, whilst technological progress may change future costs. This type of considerations may have a major impact of the assessment of costs and benefits in long-term projects, like for example infrastructure investments within the transportation sector. The Expert Committee shall examine whether and, if applicable, how changes in parameter values over time may be included in the cost-benefit calculations.

The discount rate level has a significant impact on the profitability of long-term measures. The guidelines for determining the discount rate are based on exponential discounting and the so-called Capital Asset Pricing Model. However, financial markets provide limited information about risk premiums for projects with a long economic life, such as for example transportation investments. The Stern Review has recommended a discount rate of 1.4 percent for climate calculations, whilst other economists have argued that such estimate is too low. The Committee shall assess, against this background, which discount rate should be applied in respect to long-term measures, and whether the required rate of return should be differentiated on the basis of the duration of such measures. The Committee shall review existing literature within this area, and assess various methods for determining the discount rate. The Committee shall consider, in this context, whether the theoretical framework for determining the discount rate should be based on the opportunity cost of capital or on consumer behaviour. Moreover, both the cost side and the benefit side are subject to systematic uncertainty from a portfolio perspective. The Committee shall make a recommendation as to how systematic uncertainty should be handled in public investment analysis.

There is considerable uncertainty associated with future international climate negotiations, and consequently with future emission prices. By basing the cost-benefit analysis of public measures on uniform assumptions with regard to the future prices of greenhouse gas emissions, everyone preparing calculations for public investment projects will apply the same assumptions in such respect. This will contribute to projects being dealt with in a consistent and comparable manner. The NOU 2009: 16 Green Paper; “Global Environmental Challenges - Norwegian Policy”, recommends that a carbon price path be included in the cost-benefit analysis circular of the Ministry of Finance, thus making this mandatory for all central government cost-benefit analysis. The Expert Committee shall assess the said recommendation and propose potential guidelines for the pricing of greenhouse gas emissions in view of two alternatives; one carbon price path that reflects current expectations with regard to future prices in the EU ETS, and one path that supports the 2-degree target supported by Norway.

Furthermore, the Expert Committee shall consider how cost-benefit analysis is to deal with catastrophic effects with a small, but not negligible, probability, as well as the matter of irreversible effects.

The Committee shall assess how gains from, for example, transportation investments should be dealt with in cost-benefit analysis, including benefits that are currently often not assigned a price tag in cost-benefit analysis, such as productivity effects from increased geographic density, increased labour supply, as well as the interaction between transportation services and land use. The Committee shall assess how the framework may potentially be made more specific when taking into consideration any net contribution from wider impacts of a public transport measure.

The guide published by the Ministry of Finance does not prescribe the analysis period for a measure. The discrepancy between the analysis period and the technical lifespan is in certain sectoral guides dealt with by calculating a residual value as per the end of the analysis period. The Committee shall assess how the analysis period and the residual value should be determined.

The cost-benefit analysis guide offers general recommendations as to how one may seek to quantify the value of accident-reducing measures. This may, for example, be of relevance to cost-benefit calculations concerning safety measures within the transportation sector. The estimated value of a statistical life lost is presented in such a context. The Directorate for Health and Social Affairs recommended, in a report from 2007, the broad use of such a concept in intersectoral health impact assessments. The Committee shall examine what weight intersectoral cost-benefit assessment standards should carry in the evaluation of the impact on life and health, including within the health sector, and any ethical issues that may be raised thereby.

Distribution weights may be used in cost-benefit analysis to specifically adjust for income distribution effects. The Committee shall assess whether and, if applicable, how income distribution effects shall be included in economic project analysis.

The work of the Expert Committee should be based on the technical work carried out in this area in Norway, including, inter alia, the NOU 1997: 27 Green Paper and the NOU 1998: 16 Green Paper on cost-benefit analysis. Besides, the Expert Committee should summarise main features of technical cost-benefit analysis developments subsequent to the established current framework. The Committee should also compare the criteria applied by some other countries within the area of cost-benefit analysis, including the United Kingdom and the Scandinavian countries.

The Expert Committee should itself evaluate the need for hiring additional experts in its work. The Committee is requested to facilitate presentation, by representatives from various sectors, on technical issues and experiences from the development and use of cost-benefit analysis before the Committee.

The Committee shall assess financial/administrative implications of its proposed measures.

The Expert Committee shall submit its recommendation to the Ministry of Finance by 1 June 2012.

1.3 The work and composition of the Committee

The Committee members were:

• Kåre P. Hagen, Professor Emeritus, Norwegian School of Economics, Chairperson

• Stein Berntsen, Executive Vice President, Dovre Group

• Brita Bye, Researcher, Statistics Norway

• Lars Hultkrantz, Professor, Örebro University

• Karine Nyborg, Professor, University of Oslo

• Karl Rolf Pedersen, Associate Professor, Norwegian School of Economics

• Maria Sandsmark, Researcher, Møreforsking Molde AS

• Gro Holst Volden, Researcher, Norwegian University of Science and Technology/SINTEF

• Geir Åvitsland, Director General, Ministry of Finance (from 1 June 2011)

The Secretariat of the Committee had the following members:

• Frode Karlsen, Deputy Director General, Ministry of Finance, Head of the Secretariat

• Gry Hamarsland, Head of Section, Norwegian Government Agency for Financial Management

• Vegard Hole, Adviser, Ministry of Finance

• Erling Motzfeldt Kravik, Adviser, Ministry of Finance

• Johan Nitter-Hauge, Senior Adviser, Ministry of Finance

• Kjartan Sælensminde, Senior Adviser, Norwegian Government Agency for Financial Management

• Elisabeth Aarseth, Senior Adviser, Norwegian Government Agency for Financial Management

Moreover, affected line ministries have been represented in the Secretariat when matters within their areas of responsibility have been under discussion. This applies to the Ministry of Transport and Communications, the Ministry of Health and Care Services and the Ministry of the Environment. The following individuals from these ministries have contributed to the work of the Secretariat:

• Beate Ellingsen, Adviser, Ministry of the Environment

• Leif Ellingsen, Adviser, Ministry of Transport and Communications

• Annelene Holden Hoff, Senior Adviser, Ministry of Transport and Communications

• Marit Måge, Senior Adviser, Ministry of Health and Care Services

• Bent Arne Sæther, Specialist Director, Ministry of the Environment

The Committee has held a total of 20 meetings in connection with the work of revising the cost-benefit analysis guidelines. In addition, two seminars with international participation have been held: one concerning net wider impacts of transportation projects; “Wider Impacts and Transport Infrastructure”, and one concerning the discount rate; “The Social Discount Rate”. Moreover, affected ministries have submitted written inputs to the Committee, and national experts in individual areas have also made presentations before the Committee. A seminar in which the ministries presented their views on, and experiences from, cost-benefit analysis has been held. On 8 December 2011, the Ministry of Finance consented, upon application from the Committee, to the deadline for completion of the work being postponed until 1 October 2012.

1.4 Recommendations

Chapter 2 discusses the fundamental cost-benefit analysis approach, including principles relating to the valuation of cost and benefit elements. These fundamental principles remain fixed and have not been subjected to renewed discussion by the Committee. The issues raised by the terms of reference are discussed by the Committee in the subsequent chapters:

• Chapter 3 Distribution effects

• Chapter 4 Real price adjustment

• Chapter 5 The social discount rate

• Chapter 6 Lifespan, analysis period and residual value

• Chapter 7 Net wider impacts of transportation projects

• Chapter 8 Disasters and irreversible effects

• Chapter 9 Carbon price paths

• Chapter 10 Valuation of life and health

• Chapter 11 Financial and administrative implications

Each Chapter addresses issues raised in the terms of reference. Moreover, the Committee presents its assessments and recommendations in each Chapter. All recommendations are unanimous. Readers are referred to the individual chapters for further details and contexts.

The recommendations of the Committee may change the ranking of various projects relative to each other, as measured by the net economic benefits of such projects. Whether this has any impact on which projects are adopted by the decision makers depends on what the decision makers emphasise when making a decision. If weight is attached to the net economic benefits, the recommendations may have an impact on which projects are implemented. If the upper budget limit remains unchanged, either nationally or within a sector, the proposals will have no budgetary consequences.

In the following are presented, based on the Committee’s discussion of the various issues, the unanimous recommendations made by the Committee in Chapters 3–10:

Chapter 3 Distribution effects:

• Cost-benefit analysis should continue to estimate the aggregate, unweighted willingness to pay. In other words, explicit distribution weighting is not recommended.

• The Committee holds the view that economic profitability shall be interpreted as a summary measure of the net amount the population as a whole is willing to pay for a project, and not as a measure of what is in the best interest of society in a wider sense. This implies that the estimated economic profitability of projects, as calculated in ordinary cost-benefit analysis without explicit welfare weights, cannot in itself be interpreted normatively as a matter of course.

• The distribution effects for especially affected groups, including any conflicts of interest, should be examined and discussed in a manner providing the decision maker with the best possible basis for taking these into consideration when assessing the public measure. It should be explained how different objectives with regard to distribution and conflicts of interest may influence the desirability of implementing the measure.

Chapter 4 Real price adjustment:

General recommendations

• Real price adjustment (up or down) should only be considered for cost and benefit components where there is a firm theoretical and empirical basis for estimating how developments in the valuation of the relevant goods will deviate from general inflation.

• When future real developments in calculation prices are subject to considerable uncertainty, and different development paths are of importance to the analysis, sensitivity calculations may be an appropriate alternative.

• Cost-benefit analysis should also present and discuss how non-priced effects may change over time.

Values of time

• The Committee recommends that the valuation of time savings be based on the opportunity cost principle. Furthermore, the Committee proposes that time use be split into two main categories: work and leisure. The Committee is of the view that more precise categories may also be used if good information is available.

• The valuation of time at work should be based on the value added lost by the employer (as measured by gross real wage costs).

• Estimates of saved/increased working hours should, to the extent practicable, reflect the effective time gain/time loss.

• The valuation of leisure should be based on willingness to pay surveys. If no such survey is available, it will be appropriate to use the net real wage as representing the value of leisure time.

• The value of time at work should be price adjusted by using the expected growth in GDP per capita.

• Correspondingly, the value of leisure time saved should be subjected to real price adjustment by using the expected growth in GDP per capita. This implies that the elasticity of the willingness to pay for leisure with regard to GDP per capita is 1.

• If possible, the values of time of the people who are affected by the measure should be used in the analysis. If adequate information about these values of time is not available, it will be appropriate to use national averages.

Environmental goods

• The Committee finds that the value of statistical lives, and the imputed calculation prices (including health and mortality-related environmental effects), should be subjected to real price adjustment based on the growth in GDP per capita.

• Calculation prices for health and mortality-related environmental effects should also be adjusted for estimated developments in the health effect of the environmental damage.

• As far as concerns calculation prices based on individual willingness to pay for environmental goods, the Committee does not think there is an adequate empirical basis for proposing general real price adjustment rules.

• Calculation prices derived from political decisions and commitments should be based on current policy and knowledge about future objectives and commitments. No adjustment should be made with respect to policy development assumptions. Such considerations may, for example, be addressed by a sensitivity analysis if deemed to be of particular relevance to the decision maker. As far as the calculation price for greenhouse gas emissions is concerned, reference is made to a separate discussion in Chapter 9.

• Factors that influence the future scarcity and importance of affected environmental goods should be presented and discussed in the economic analyses, irrespective of whether calculation prices are available and used.

Chapter 5 The social discount rate

• In principle, the real risk-adjusted social discount rate should reflect the risk-free interest rate and the risk associated with the project and, consequently, reflect the project’s risk adjusted opportunity cost of capital. The discount rate applied in the assessment of public measures should, however, nonetheless be based on simple rules that address the main aspects of the matter.

• For commercial public sector operations in direct competition with private sector, it will be appropriate to use a discount rate faced by corresponding private enterprises.

• A real risk-adjusted discount rate of 4 percent will be reasonable for use in the cost-benefit analysis of an ordinary public measure, such as a transportation measure, for effects in the first 40 years from the date of analysis.

• Beyond 40 years, it is reasonable to assume that one will be unable to secure a long-term rate in the market, and the discount rate should accordingly be determined on the basis of a declining certainty equivalent rate as the interest rate risk is supposed to increase with the time horizon. A rate of 3 percent is recommended for the years from 40 to 75 years into the future. A discount rate of 2 percent is recommended for subsequent years.

Chapter 6 Lifespan, analysis period and residual value

• A cost-benefit analysis should seek to include all relevant effects of the measure throughout its lifespan.

• The lifespan used in the analyses must reflect the period during which the measures under analysis will actually be in use or be of service to society. The lifespan therefore needs to be discussed for each project, or in sectoral guidelines within sectors where a large number of similar projects are implemented. It is appropriate for the approach within each sector to be as uniform as possible to ensure comparability between projects.

• The main principle should be to bring the analysis period as close to the lifespan as practicable. It would, for example, seem more appropriate to apply 40 years as the analysis period for road projects than the 25 years applied until now.

• If the analysis period is shorter than the lifespan of the measures, it will be necessary to calculate a residual value that estimates the total economic net present value the project is expected to generate from the end of the analysis period until the end of the project lifespan.

• Residual value should principally be calculated on the basis of the net benefit flow over the last years of the analysis period. It should be adjusted for any cyclical or other expected variations during the time interval from the end of the analysis period until the end of the lifespan of the project, for example due to a need for major upgrades or reinvestments. For projects where most effects have been valued, it should be assumed that the flow of net benefits will approach zero in the last year of the lifespan.

• The best possible method should be used in the event of any knowledge and documentation, including any market value estimate, suggesting that a different method for calculating the residual value of the specific measure in question would be better.

• If the residual value period is assumed to be long and the effects (and thus the lifespan) are subject to considerable uncertainty, sensitivity analysis and scenario analysis should be used as supplementary analysis methods to shed light on the importance of particularly uncertain estimates.

Chapter 7 Net wider impacts of transportation projects

Productivity and economies of scale

• It has proven very difficult to identify a relationship between town size and productivity when evaluating the effect of a transportation project or a series of such projects subsequent to its or their implementation. According to the view of the Committee it cannot, therefore, be recommended to generally assume such a relationship when evaluating a project prior to its implementation.

• Since the literature gives reason to believe that there may be positive net wider impacts of transportation projects in urban areas, the cost-benefit analysis of large projects in connection with an urban area in which it can be shown to be probable that productivity is systematically higher, may be expanded to include a separate discussion of net wider impacts. Such an analysis may be both qualitative and quantitative, and should discuss whether such effects are likely to materialise. However, in order to ensure comparability across projects, and in view of the uncertainty, any quantitative findings from such a supplementary analysis should only constitute a supplement to a main analysis of the net economic benefit associated with a project.

Labour supply

• For major projects concerning which it can be shown to be probable, on an empirical basis, that the project will influence overall labour supply in the country through increased working hours, or through increased labour force participation, a cost-benefit analysis could be expanded with a separate discussion of these effects. Such an analysis may be both qualitative and quantitative, and should discuss whether such effects are likely to materialise. It is important to avoid double counting of the benefits from the project in such contexts, and the correct approach will in practice be to only take into account the change in tax revenues as the result of higher employment. However, in order to ensure comparability, and in view of the uncertainty, any quantitative findings from such a supplementary analysis should only constitute a supplement to the main analysis of the net economic benefits associated with the project.

Land use and transportation

• As a main rule, price changes in the property market as the result of a transportation project only represent a redistribution of the original direct benefits from such project. Including both effects in the analysis will therefore amount to double counting. If one has sought to estimate the value of increased productivity as the result of increased functional city size directly, it will also amount to double counting if the property market implications of such effects are taken into account. In those cases where a transportation project releases areas with a positive opportunity value, there may be a real economic effect that is not reflected in the direct user benefits of the project.

Imperfect competition

• Based on the available documentation, the Committee is not in a position to conclude as to whether the effect on imperfect competition is of any material importance to the net economic benefit of transportation projects. The review also shows that it is difficult to establish any simple method for identifying any such potential effect in a robust manner, and with a solid empirical basis. If it can be shown to be probable, on an empirical basis, that the project may influence the degree of competition, or that it will influence markets that are in particular characterised by imperfect competition, a cost-benefit analysis may be expanded to include a separate discussion of these effects. However, in order to ensure comparability, and in view of the uncertainty, any quantitative findings from such a supplementary analysis should only constitute a supplement to a main analysis of the net economic benefits associated with a project.

The ex post analysis of the primary markets

• The effort to analyse projects subsequent to their implementation should be continued. A systematic approach, like that adopted by the Norwegian Public Roads Administration, generates new knowledge about the analyses carried out, and makes it possible to use these findings to improve the estimates. The systematic follow-up of such studies and other approaches may contribute to ensuring that the specification of the cost and benefit elements is complete, that projections are correct in the long run, and that there are no other sources of incorrect estimates within the cost-benefit analysis framework.

Chapter 8 Disasters and irreversible effects

• When faced with irreversible effects, it will at times be possible to get more information about the effects of the measures by postponing execution. In formal terms, this may be expressed as a (quasi-)option value. Such values may be difficult to estimate, but the advantages of postponing implementation should nevertheless be described and assessed.

• In the cost-benefit analysis of situations with a potentially catastrophic outcome, it is important to examine whether or not the probability of such catastrophic outcome is negligible. In order to safely ignore a disaster probability it is, in principle, necessary to know 1) that the level of the disaster probability is very low, 2) that the level of the disaster probability is well known (and therefore not uncertain in itself), and 3) that the cost increase in the event of more extreme outcomes is not sufficiently steep to (in full or in part) outweigh the fact that more extreme outcomes are less probable.

• If the probability is not negligible, or if one is unable to conclude that such is the case, the standard method of analysis may underestimate, potentially to a significant extent, the cost associated with society being exposed to an unknown degree of disaster risk. The Committee is of the view that one should in such cases attach considerable weight to describing both what one knows about the possibility of catastrophic outcomes, as well as the knowledge deficiencies as the decision makers have to be aware of. The level of ambition will usually, at least implicitly, be determined as a “safe minimum standard”.

• Cost-benefit analysis should be used to highlight what amount of resources used, implicitly or explicitly, for risk reduction within various sectors, in order to improve the basis for making decisions about sensible resource allocation. The theoretical literature within the area of safety regulation is in development. Various types of breakeven analysis may provide information about the minimum probability of a terrorist act, or a similar incident, that may justify a safety regulation.

Chapter 9 Carbon price paths

• The current differentiated tax and quota structure for the private sector is not suitable for use in cost-benefit analysis. A joint carbon price path should be applied for purposes of cost-benefit analysis.

• The appropriate calculation price for greenhouse gas emissions depends on what question one would like the analysis to answer. The Committee adopts the assumption that the authorities are subject to binding emission limitation targets, thus implying that increased emissions in one location necessarily have to be compensated by reductions elsewhere. The Committee recommends, on this basis, that the calculation price for greenhouse gas emissions be based on the marginal cost of emission reductions (the marginal abatement cost). If there are no binding emission limitation targets, the carbon price path should, in principle, be based on the marginal social cost of carbon instead.

• If the authorities are subject to binding domestic emission reduction targets, the calculation prices should be derived from the constraints resulting from such targets. Climate Cure 2020 (2010) has calculated a number of such paths towards 2020.

• If binding Norwegian targets are related to the contribution to total global emissions caused by Norway, and Norwegian emissions are subject to an international cap-and-trade system, the calculation price for greenhouse gas emissions should be based on expectations as to the international allowance price. From the various allowance prices in current international trading systems, the Committee recommends the use of the EU ETS allowance price. The path should be based on market expectations of future allowance prices. For years in respect of which no prices are quoted, the price path should over time approach an assumed two-degree path based on internationally recognised model computations.

• For projects where the cost-benefit analysis is particularly sensitive to different carbon price paths, it will be useful to prepare sensitivity estimates assuming a two-degree path for all years.

If the national or international political situation changes, such as to make new climate targets binding on the Norwegian economy, it is the marginal abatement cost given these new targets that should form the basis for the main joint calculation price alternative for greenhouse gas emissions.

If Norway finds itself, in future, in a situation where the authorities are not subject to binding emission reduction targets, thus implying that emission increases in one location cannot be assumed to imply emission reductions elsewhere, the carbon price path in cost-benefit analysis should, in principle, be based on the marginal social cost of carbon.

The specific paths should be prepared by the Ministry of Finance in consultation with other affected ministries.

Chapter 10 Valuation of life and health

• Health indicators will have to be chosen on the basis of the specific character of the public measures in question. It will, for example, be more appropriate to use statistical life-years than statistical lives when expected remaining life years deviate sharply between alternative measures. Correspondingly, it will be more appropriate to use indicators for quality-adjusted life years when improved health-related quality of life is an important consequence. It may also be relevant to use specific health indicators.

• It is not necessary to attribute an economic value to the health indicators statistical lives, statistical life-years or quality-adjusted life years in order to include these in cost-effectiveness analysis or cost-effect analysis.

• It is proposed an economic value of a statistical life (VSL) at NOK 30 million at 2012 prices. It is recommended that this be applied to all sectors (cf. intersectoral standard in the terms of reference).

• In the analyses of measures specifically targeting the safety of children one may apply, by way of supplementary analysis, a higher value of a statistical life than for the general population. An appropriate level is twice the VSL of the general population.

• In principle, the value of equivalent consequences should be the same irrespective of sector, also for other health-related benefit indicators, like value of a statistical life year (VOLY) and quality-adjusted life years (QALY). However, the Committee is of the view that the technical basis for estimating the willingness to pay for these is currently not sufficiently established to merit the recommendation of intersectoral standard values for VOLY and QALY.

• It is proposed that the economic value of VSL be adjusted in line with the growth in GDP per capita (cf. Chapter 4 on real price adjustments).

• For measures where effects on life and health represent a main consequence, especially where the measures imply significant risk changes for individuals and/or where the identity of those especially affected is known, it will often be more appropriate to use cost-effectiveness analysis or cost-effect analysis than cost-benefit analysis (as a specific method of analysis).