Risk and time in SCBA s: a practioners view
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1 RMNO Conference Risk and time in SCBA s: a practioners view Prof dr Casper van Ewijk CPB / University of Amsterdam Scheveningen January 17, 2008
2 CPB: Many different areas
3 SBCA s in the Netherlands SCBC s for (almost) all major public projects performed by CPB and other research institutes advice by high level committee common guidelines OEI ( Analysis Effects Infrastructure ) = the Dutch Green book (CPB et al. 2000, 2004)
4 Process of SCBA 1. quick scan / full SCBA 2. careful project definition relative to best alternative! 3. critical assesment of inputs lots of common sense SCBA: net present value valuation of (environmental) externalities if possible if not: reporting of effects uncertainty about assumptions: => sensitivity analysis / scenario s
5 discount rate Risk and time in official guidelines real risk free rate 2.5% (revised in 2007) valuation of risk so far, focus on infrastructure projects aim at market value risk valuation preferably project specific focus on non-diversifiable risk observed required rates of return or covariance with market risk => beta s default: risk premium on top of discount rate 3%
6 Can be different in a number respects Environmental SCBA s non-marginal impact e.g. climate change type of risks non-marginal risks: catastrophies / fat tails difficulty in valuation (e.g. bio diversity) an a fortiori the risk characteristics of this value long time horizon but not necessarily so most environmental evaluation fits in standard approach often possible to transform problem into cost-effectiveness problem that is: given particular environmental constraints e.g. SCBA of windmills given Kyoto targets
7 Decision tree SCBA (first glance) Risk valuation & discounting Marginal - small project - normal risks Non-marginal - large project - extreem risks Fundamental lack of knowledge - value / effects long term medium term transformed into cost effectiveness other other standard SCBA declining discount rate? standard SCBA????
8 Getting concepts straight (I) discount rate in marginal analysis (finance literature) risk free rate (term structure) applied to certainty equivalent in consumption terms C(t) so, after accounting for the value of risk and after accounting for changes in relative prices in non-marginal analysis (environmental literature: climate change) the discount rate does not exist (endogenous)
9 valuation of risk Getting concepts straight (II) distinct from discounting time distinguish: diversifiable risks => no value non-diversifiable risks => positive / negative value different issue: option value irreversibility (e.g. due to sunk costs) NPV no longer proper investment criterion (Pyndick & Dixit)
10 Non-marginal analysis The discount rate does not exist in non-marginal analysis Ramsey rule issues: is state (C(t)) specific r( Ct ) = δ + η ( Ct ) g( Ct => general equilibrium analysis state contingent (Arrow Debreu) prices empirical basis for modeling: what preferences? no information if far from actual realizations standard model fails: equity premium puzzle -> Epstein-Zin preferences? how to take account of fat tails / small risks large consequences (Stern, Weitzman) )
11 Marginal analysis (I) Given (market) prices discount rate = risk free rate of return risk valuation - only non-diversifiable risk - (C)CAPM model: beta s - applies to value of (environmental) externalities as well in specific cases: time invariant premium on risk free discount rate: d = r + π only for rising (co)variance over time basis: random process in C, and therefore U (C)
12 Marginal analysis (II) Issues capital market distortion (equity premium puzzle)? mixed evidence note: more public investment is not (first best) solution sub-optimal intergenerational distribution (policy failure)? no evidence note: more public investment is not (first best) solution is uncertainty about proper discount rate reason for lower rate? (Weitzman) not if it is only Jensen s inequality... term structure of risk free rate missing or thin markets for long time horizon falling risk free rate for distant future? e.g. due to ageing or declining growth term structure of the risk premium - falling over long time horizon?
13 Decision tree SCBA Risk valuation & discounting Fundamental lack of knowledge Marginal - small project - normal risks Non-marginal - large project - extreem risks long term ageing, climate change -only non-diversifiable risk -missing market prices? -falling discount rate? -falling risk premium? medium term infrastructure standard SCBA -only non-diversifiable risk -market prices -valuation externalities if it makes sense transformed into cost effectiveness energy supply reducing CO2 other climate change stochastic general equilibrium analysis or ad hoc approach (Stern)
14 Conclusions Aart s proposition on social discount rate being superior to (social) discount rate based on market prices is far to general, and therefore wrong. Different prices for environmental evaluation? no one price for time and risk (as for labour, bricks,...) necessary condition for efficiency but do take account of specific risk and time features of environmental processes
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