Guide to economic evaluation of transport projects: Part 1 – Principles of cost-benefit analysis

Debates over major transport investments often get caught up in arguments over benefit-cost ratios, or BCRs. In recent years, projects such as the Transmission Gully and Puhoi to Warkworth motorways and the City Rail Link have been criticised for their low BCRs. These debates have often raised more questions than they resolve. So it’s necessary to ask: What is a BCR, how is it calculated, and what does it mean?

The good news is that there is a manual that explains it – New Zealand Transport Agency’s Economic Evaluation Manual (EEM). The bad news is that it’s tediously long and not written for a general audience. This series of posts aims to provide a guide for the perplexed. In it I will cover issues such as the principles of cost benefit analysis, the identification of economic benefits arising from transport projects, forecasting of transport outcomes, and accounting for the land-use impacts of transport projects.

Part one of this series provides a high-level overview of the principles of cost-benefit analysis.

Cost-benefit analysis, or CBA, is the general approach used to evaluate transport projects and many other public investments. It is commonly used by both local and central government for project evaluation, although it is not strictly required in all situations. (The Treasury’s Better Business Case guidelines, which apply to most public investment, provide an indication of which areas are covered by the standard approach.) The output from a CBA is a benefit-cost ratio that compares a project’s net benefits to society with its net costs to society and allows a funding agency to compare different projects in a consistent way.

CBA, which estimates the economic efficiency of a project, is not necessarily the only input to project evaluation. In recent years, NZTA has introduced several additional criteria to its assessment framework – “strategic fit” and “effectiveness”. In practice, these are more nebulous than CBA, and as a result I may leave them for a future post.

NZTA and other agencies such as Auckland Transport use CBA for two main purposes:

• First, in order to choose a preferred solution to a particular transport problem. For example, AT’s 2012 City Centre Future Access Study (CCFAS) used CBA to compare six different options for adding capacity to city centre-based transport networks and concluded that the CRL was the best-performing option.
• Second, in order to prioritise its investment portfolio. NZTA generally uses project BCRs to choose how to allocate funds to different projects within its funding categories. For example, when choosing how to allocate its walking and cycling budget, which totalled $53 million from 2012-2015, it would generally select the projects with the highest BCRs. Same deal for the budget for new and improved local road infrastructure – although these projects often have much lower BCRs than the walking and cycling ones, since NZTA is obliged to spend a greater share of its funding on them ($475 million over 2012-2015), regardless of the relative BCRs.

Cost-benefit analyses are generally conducted using a similar set of underlying principles. CBA seeks to:

• Quantify all costs and benefits to society regardless of their incidence, or who benefits or pays
• Identify the net benefits and costs of a project relative to a “do-minimum”, or what would have happened anyway
• Consider benefits and costs over a longer forecast period, with future costs and benefits discounted to present values.

Worked example – a new bus line for Ruritania

In order to explain how CBA can be applied to transport evaluation, I’m going to present a simple worked example. In this example, a fictional transport agency in Ruritania, a small central European country, has noticed that transport demands are increasing in the capital city, Streslau. In particular, car congestion is worsening on the arterial road between two outlying neighbourhoods that are about 5 km apart from each other. We’ll call these neighbourhoods A and B.

Like many other European cities, Streslau has a mix of transport networks. Several subway lines were constructed during the 1920s, but work stopped during the Great Depression and never resumed after World War II. The post-war Communist government scrapped the damaged tramlines and replaced them with a mix of trolleybuses and diesel buses that mostly provide radial service to the city centre. In the early 2000s, a light rail line was built to connect the newly expanded airport to the city centre.

Unfortunately, none of these directly serve trips between A and B, and Streslau’s transport planners would like to add a new public transport service to meet demand on this route. Prior to the global financial crisis, the Ruritanian government had been considering borrowing money for a light rail line, but European austerity policies scuppered that plan. Now the transport agency must focus on finding a cheaper option that still provides good service between A and B. They’re investigating different options for a new bus line.

CBA principle: Identify all costs and benefits to society

Cost-benefit analysis aims to quantify all costs and benefits to society, regardless of who bears them or benefits. All of the effects of a project should be considered. When considering the benefits of a transport project, it would be incorrect to account for the benefits that a project would have to one group of transport users without considering any disbenefits or negative effects on other users.

In our Ruritanian example, let’s say that the transport agency was considering converting two traffic lanes to bus lanes to enable it to run a fast service between A and B. This would have benefits for bus users: they would get a quicker trip. But it may also inconvenience the remaining drivers, who might find it harder to make turns or pass turning cars. It’s also possible that motorists might benefit from a quicker trip, thanks to reduced congestion. CBA should account for all of these effects.

Similarly, when calculating the cost of a project, it is important to add up all costs. In our Ruritanian example, adding a new bus route will require both capital expenditure (capex) and operating expenditure (opex) from the transport agency. Capex includes any spending on infrastructure, such as painted bus lanes, new bus shelters, reconstructed intersections, new vehicles, etc. Opex refers to the annual, ongoing spending required to keep the buses running – drivers’ wages and benefits, fuel, maintenance costs, etc. Any changes in the costs of owning and operating private vehicles are generally counted on the “benefits” side of the equation, rather than the cost side.

Streslau’s transport agency will be able to recover some of these costs from public transport fares. If it’s like New Zealand, fares might cover 50% of the operating costs. If it’s more like most European cities, fares might be lower and only cover 15-20% of operating costs. In any case, it’s not important here, as CBA doesn’t distinguish between public and private costs. It’s worth knowing, though, that the “C” reported in a BCR doesn’t always reflect the net cost to government.

CBA principle: Compare projects against a “do-minimum”

In transport, it is seldom possible to do nothing. Even if nothing else is changing with your transport system, it will still be necessary to spend a significant amount of money on maintaining and operating the system. Even if car congestion is an acceptable level and traffic volumes aren’t growing, you’ll have to spend money fixing potholes and resurfacing streets. Likewise, a PT system that’s standing still will still be paying drivers, buying replacement vehicles, and repainting bus shelters and stations.

Consequently, an important part of transport CBA is the identification of a realistic do-minimum, or the minimum amount that could be done to ensure that the existing system continues to operate. The do-minimum forms the baseline against which you evaluate all other options. In some cases, the do-minimum will include some costs that you are able to avoid by implementing another project.

To return to Streslau: let’s say that the city’s transport agency has found that if nothing else were done, it would need to add new turning lanes to three intersections on the road from A to B to avoid gridlock. The do-minimum should therefore include the cost of three intersection widenings. If adding a new bus route would avoid the need for this spending, it should be subtracted from the net cost of the bus route.

Likewise, transport CBA should consider the net benefits rather than the total benefits. For example, let’s say that the owners of a large pickle factory in neighbourhood B are planning on relocating the plant to a provincial town in two years’ time. This will reduce the number of people commuting by car along the road from A to B, whether or not a new bus route is introduced. This should be considered when evaluating the new bus route, to ensure that the project doesn’t take credit for some reductions in congestion that would have occurred anyway.

CBA principle: Consider costs and benefits over a longer time period

Transport infrastructure projects often have impacts over a long time period. For example, every day tens of thousands of people travel across the Auckland Harbour Bridge, which was opened in 1959 and expanded a decade later. Similarly, Wellingtonians make over ten million trips a year on the regional rail network, which was electrified in the 1930s. Transport projects often have significant up-front costs that must be compared against benefits that accrue over a longer period.

In order to do so, CBA typically forecasts future costs and benefits over a long time horizon and discounts them to present value (PV) for comparison. In order to discount future effects, it is common to use a discount rate that reflects trade-offs between costs/benefits experienced today and those experienced at a future date. For example, using a discount rate of 10% means that if you expect to earn $100 in a year’s time, it will have a PV of $90 (=$100*(1-0.1)^1).

Using a higher discount rate implies that you place a lower value on future outcomes relative to future outcomes, and vice versa. The choice of discount rates can have some interesting implications for decision-making, as previously discussed on this blog.

In New Zealand, BCRs must be calculated using standardised evaluation periods and discount rates to ensure that they can be compared. However, it’s important to know that different agencies have different rules:

• NZTA, which funds road projects out of a dedicated fund, announced last year that it would use an evaluation period of 40 years and a discount rate of 6% to assess its projects.
• The Treasury, which funds most other government investments, including rail infrastructure projects, continues to require an evaluation period of 30 years and a discount rate of 8%. In effect, the Treasury’s approach places less weight on long-term outcomes than NZTA’s approach.

Let’s conclude by considering how this may apply to our Ruritanian example. Let’s assume, for the moment, that Streslau’s transport planners have determined that the project will have the following net costs and benefits:

• $15 million in net capex at the outset, for purchasing new buses, building bus shelters, painting bus lanes, and adding bus priority to some intersections
• An additional $2 million in ongoing annual opex to run the buses
• Net annual transport benefits relative to the do-minimum scenario in which road users cannot avoid congestion on the road that start at $6 million in the first year of operation and increase by 5% per annum as bus ridership increases.

These costs and benefits are summarised in the following graph:

It is difficult to look at this graph and determine whether the long-term benefits – shown in the green line – outweigh the significant up-front costs and ongoing operating costs – shown in the blue and red bars. However, Streslau’s transport planners can use the principles described above to calculate the present value of future costs and benefits. The table below calculates the present value of costs and benefits over a 30-year time horizon, using three alternative discount rates.

As you can see, it looks like Streslau’s transport planners will be able to make the case that the new bus line will benefit the city.

Next time: Wait, what do you mean when you talk about transport benefits?

Share this