Incorporating Risk in Benefit-Cost Analysis
If benefit-cost analysis is to assist in the decision-making process the analysis must be conducted in advance of the project being undertaken. This means that the value of none of the variables involved in the analysis can be observed, but rather has to be predicted. Risk and uncertainty are always associated with predictions about the future and should be taken into account in the benefit-cost analysis. Since risk and uncertainty impose costs on decisionmakers, these costs need to be assessed and measures taken to reduce them if possible. One way of reducing risk and uncertainty is to acquire additional information – what a benefit-cost analysis does – and the value of information is briefly discussed in Chapter 10. The present Chapter discusses the related concepts of risk and uncertainty.
In the preceding Chapters, exercises and case studies we have assumed that all costs and benefits to be included in a cash flow are known with certainty. While this assumption might be acceptable in the context of project evaluation where the analyst is undertaking an ex post assessment of what has already occurred, it is clearly an unrealistic assumption to make where the purpose of the analysis is to undertake an appraisal of proposed projects where one has to forecast future cost and benefit flows. The future is uncertain: we do not know with certainty what the future values of a project's costs and benefits will be.
Uncertainty arises either because of factors internal to the project – we do not know precisely what the future response will be to, say, some management decision or action taken today – or, because of factors external to the project – for instance, we do not know precisely what the world prices of the project's traded inputs and outputs will be. In brief, uncertainty implies that there is more than one possible value for any project's annual net benefits. The range of possible values a variable can take may vary considerably from one situation to another, with the two extremes being complete certainty, where there is one known value, to complete uncertainty where the variable could take on any value. Most situations lie somewhere between the two extremes.
Where it is believed that the range of possible values could have a significant impact on the project's profitability, a decision about the project will involve taking a risk. In most situations there will be some information on which to base an assessment of the probability of