Tag: risk

It is commonplace to use cost–benefit analysis (CBA) in assessing public policies, such as whether to build a new hospital, road or rail line. Various attempts in the past few months have been made to use CBA in assessing policies to reduce the spread of the coronavirus. These have involved weighing up the costs and benefits of national or local lockdowns or other containment measures. But, as with other areas where CBA is used, there are serious problems of measuring costs and benefits and assessing risks. This is particularly problematic where human life is involved and where a value has to be attached to a life saved or lost.

Take the case of whether the government should have imposed a lockdown: an important question if there were to be a second wave and the government was considering introducing a second lockdown. The first step in a CBA is to identify the benefits and costs of the policy.

Identifying the benefits and costs of the lockdown

The benefits of the lockdown include lives saved and a reduction in suffering, not only for those who otherwise would have caught the virus but also for their family and friends. It also includes lives saved from other diseases whose treatment would have been put (even more) on hold if the pandemic had been allowed to rage and more people were hospitalised with the virus. In material terms, there is the benefit of saving in healthcare and medicines and the saving of labour resources. Then there are the environmental gains from less traffic and polluting activities.

On the cost side, there is the decline in output from businesses being shut and people being furloughed or not being able to find work. There is also a cost from schools being closed and children’s education being compromised. Then there is the personal cost to people of being confined to home, a cost that could be great for those in cramped living conditions or in abusive relationships. Over the longer term, there is a cost from people becoming deskilled and firms not investing – so-called scarring effects. Here there are the direct effects and the multiplier effects on the rest of the economy.

Estimating uncertain outcomes

It is difficult enough identifying all the costs and benefits, but many occur in the future and here there is the problem of estimating the probability of their occurrence and their likely magnitude. Just how many lives will be saved from the policy and just how much will the economy be affected? Epidemiological and economic models can help, but there is a huge degree of uncertainty over predictions made about the spread of the disease and the economic effects, especially over the longer term.

One estimate of the number of lives saved was made by Miles et al. in the NIESR paper linked below. A figure of 440 000 was calculated by subtracting the 60 000 actual excess deaths over the period of the lockdown from a figure of 500 000 lives lost which, according to predictions, would have been the consequence of no lockdown. However, the authors acknowledge that this is likely to be a considerable overestimate because:

It does not account for changes in behaviour that would have occurred without the government lockdown; it does not count future higher deaths from side effects of the lockdown (extra cancer deaths for example); and it does not allow for the fact that some of those ‘saved’ deaths may just have been postponed because when restrictions are eased, and in the absence of a vaccine or of widespread immunity, deaths may pick up again.

Some help in estimating likely outcomes from locking down or not locking down the economy can be gained by comparing countries which have taken different approaches. The final article below compares the approaches in the UK and Sweden. Sweden had much lighter control measures than the UK and did not impose a lockdown. Using comparisons of the two approaches, the authors estimate that some 20 000 lives were saved by the lockdown – considerably less than the 440 000 estimate.

Estimating the value of a human life

To assess whether the saving of 20 000 lives was ‘worth it’, a value would have to be put on a life saved. Although putting a monetary value on a human life may be repugnant to many people, such calculations are made whenever a project is assessed which either saves or costs lives. As we say in the 10th edition of Economics (page 381):

Some people argue ‘You can’t put a price on a human life: life is priceless.’ But just what are they saying here? Are they saying that life has an infinite value? If so, the project must be carried out whatever the costs, and even if other benefits are zero! Clearly, when evaluating lives saved from the project, a value less than infinity must be given.
 
Other people might argue that human life cannot be treated like other costs and benefits and put into mathematical calculations. But what are these people saying? That the question of lives saved should be excluded from the cost–benefit study? If so, the implication is that life has a zero value! Again this is clearly not the case.

In practice there are two approaches used to measuring the value of a human life.

The first uses the value of a statistical life (VSL). This is based on the amount extra the average person would need to be paid to work in a job where there is a known probability of losing their life. So if people on average needed to be paid an extra £10 000 to work in a job with a 1% chance of losing their life, they would be valuing a life at £1 000 000 (£10 000/0.01). To avoid the obvious problem of young people’s lives being valued the same as old people’s ones, even though a 20 year-old on average will live much longer than a 70 year-old, a more common measure is the value of a statistical life year (VSLY).

A problem with VSL or VSLY measures is that they only take into account the quantity of years of life lost or saved, not the quality.

A second measure rectifies this problem. This is the ‘quality of life adjusted year (QALY)’. This involves giving a value to a year of full health and then reducing it according to how much people’s quality of life is reduced by illness, injury or poverty. The problem with this measure is the moral one that a sick or disabled person’s life is being valued less than the life of a healthy person. But it is usual to make such adjustments when considering medical intervention with limited resources.

One adjustment often made to QALYs or VSLYs is to discount years, so that one year gained would be given the full value and each subsequent year would be discounted by a certain percentage from the previous year – say, 3%. This would give a lower weighting to years in the distant future than years in the near future and hence would reduce the gap in predicted gains from a policy between young and old people.

Conclusion

Given the uncertainties surrounding the measurement of the number of lives saved and the difficulties of assigning a value to them, it is not surprising that the conclusions of a cost–benefit analysis of a lockdown will be contentious. And we have yet to see what the long-term effects on the economy will be. But, at least a cost–benefit analysis of the lockdown can help to inform discussion and help to drive future policy decisions about tackling a second wave, whether internationally, nationally or locally.

Articles

Questions

  1. What are the arguments for and against putting a monetary value on a life saved?
  2. Are QALYs the best way of measuring lives saved from a policy such as a lockdown?
  3. If the outcomes of a lockdown are highly uncertain, does this strengthen or weaken the case for a lockdown? Explain.
  4. What specific problems are there in estimating the number of lives saved by a lockdown?
  5. How might the age distribution of people dying from Covid-19 affect the calculation of the cost of these deaths (or the benefits or avoiding them)?
  6. How might you estimate the costs to people who suffer long-term health effects from having had Covid-19?
  7. What are the arguments for and against using discounting in estimating future QALYs?
  8. The Department of Transport currently uses a figure of £1 958 303 (in 2018 prices) for the value of a life saved from a road safety project. Find out how this is figure derived and comment on it. See Box 12.5 in Economics 10th edition and Accident and casualty costs, Tables RAS60001 and RA60003, (Department of Transport, 2019).

One of the announcements in the recent UK Budget was the ending of the Private Finance Initiative (PFI), including its revised form, PF2. PFI was introduced by the Conservative government in 1992. Subsequently, it was to become central to the Labour government’s ‘Third-way’ approach of using the private sector to deliver public projects and services.

PFI involves a public–private partnership (PPP). The private sector builds and/or runs public projects, such as new schools, hospitals, roads, bridges, student accommodation, and so on. The public sector, in the form of government departments, NHS foundation trusts, local authorities, etc., then pays the private sector company a rent for the infrastructure or pays the company to provide services. The benefit of PFI is that it allows private-sector capital to be used for new projects and thus reduces the need for government to borrow; the disadvantage is that it commits the public-sector body to payments over the long-term to the company involved.

As the chart shows, PFI became an important means of funding public service provision during the 2000s. In the 10-year period up to financial year 2007/08, more than 50 new projects were being signed each year.

As the number of projects grew and with them the long-term financial commitments of the public sector, so criticisms mounted. These included:

  • Quality and cost. It was claimed that PFI projects were resulting in poorer quality of provision and that cost control was often poor, resulting in a higher burden for the taxpayer in the long term.
  • Credit availability. PFI projects are typically dependent on the private partner using debt finance to acquire the necessary funds. Therefore, credit conditions affect the ability of PFI to fund the delivery of public services. With the credit crunch of 2008/9, many firms operating PFI projects found it difficult to raise finance.
  • The financial health of the private partner. What happens if the private company runs into financial difficulties. In 2005, the engineering company Jarvis only just managed to avoid bankruptcy by securing refinancing on all 14 of its PFI deals.

PF2

Recognising these problems, in 2011 the government set up a review of PFI. The result was a revised form of PFI, known as ‘PF2’. PF2 projects involved tighter financial control, with the government acting as a minority co-investor; more robust tendering processes, with bidders required to develop a long-term financing solution, where bank debt does not form the majority of the financing of the project; the removal of cleaning, catering and other ‘soft services’.

Despite the government’s intention that PPPs remain an important plank of its funding of public services, the number of new PFI/PF2 projects has nonetheless declined sharply during the 2010s as the chart shows. Of the 715 PPP projects as of 31 March 2017, 631 had been signed before May 2010. Indeed, in 2016/17 only 1 new project was signed.

The collapse of Carillion

Concerns over PPPs remained despite the reforms under PF2. These were brought dramatically into focus with the collapse of Carillion plc (see the blog, Outsourcing, PFI and the demise of Carillion). Carillion was a British company focused on construction and facilities management (i.e. support services for organisations). It was a significant private-sector partner in PPP projects. By 2014 it had won 60 PPP projects in the UK and Canada, including hospitals, schools, university buildings, prisons, roads and railways.

However, Carillion had increasing burdens of debt, caused, in part, by various major acquisitions, including McAlpine in 2008. Events came to a head when, on 15 January 2018, an application was made to the High Court for a compulsory liquidation of the company.

A subsequent report for the House of Commons Public Administration and Constitutional Affairs Committee in light of the collapse of Carillion found that procurement procedures were fundamentally flawed. It found that contracts were awarded based on cost rather than quality. This meant that some contracts were not sustainable. Between 2016 and the collapse of Carillion the government had been forced to renegotiate more than £120m of contracts so that public services could continue.

The ending of PPPs?

On 18 January 2018, the National Audit Office published an assessment of PFI and PF2. The report stated that there were 716 PFI and PF2 projects at the time, either under construction or in operation, with a total capital value of £59.4 billion. In recent years, however, ‘the government’s use of the PFI and PF2 models had slowed significantly, reducing from, on average, 55 deals each year in the five years to 2007/8 to only one in 2016/17.’

At its conference in September 2018, the Labour shadow chancellor, John McDonnell, said that, if elected, a Labour government would not award any new PFI/PF2 contracts. He claimed that PFI/PF2 contracts were set to cost the taxpayer £200bn over the coming decade. Labour policy would be to review all existing PFI/PF2 contracts and bring the bulk of them fully back into the public sector.

Then in the Budget of 29 October 2018, the Chancellor announced that no further PFI/PF2 projects would be awarded, although existing ones would continue.

I have never signed off a PFI contract as chancellor, and I can confirm today that I never will. I can announce that the government will abolish the use of PFI and PF2 for future projects.

We will honour existing contracts. But the days of the public sector being a pushover, must end. We will establish a centre of excellence to actively manage these contracts in the taxpayers’ interest, starting in the health sector.

But does this mean that there will be no more public-private partnerships, of which PFI is just one example? The answer is no. As the Chancellor stated:

And in financing public infrastructure, I remain committed to the use of public-private partnership where it delivers value for the taxpayer and genuinely transfers risk to the private sector.

But just what form future PPPs will take is unclear. Clearly, the government will want to get value for money, but that depends on the mechanisms used to ensure efficient and high-quality projects. What is more, there is still the danger that the companies involved could end up with unsustainable levels of debt if economic circumstances change and it will still involve a burden on the taxpayer for the future.

Articles

Questions

  1. Find out how PF2 differs from PFI and assess the extent to which it overcame the problems identified with PFI.
  2. The government is not bringing back existing PFI contracts into the public sector, whereas the Labour Party would do so – at least with some of them. Assess the arguments for and against bringing PFI contracts ‘in-house’.
  3. Find out why Carillion collapsed. To what extent was this due to its taking on PFI contracts?
  4. What were the main findings of the National Audit Office’s assessment of PFI and PF2?
  5. The government still supports the use of public-private partnerships (PPPs). What form could these take other than as PFI/PF2 contracts? Would the problems associated with PFI/PF2 also apply to PPPs in general?

How much do you know about cryptocurrencies? Even if you don’t know much you are very likely to have heard about the most popular member of the family: Bitcoin. Bitcoin (BTC) has been around for some time now (see the blog Bubbling Bitcoin). It was first released in 2009 by its inventor (the mysterious Satoshi Nakamoto, whose real identity still remains unknown), and since then it has gradually increased in popularity.

According to the Bitcoin Market Journal (a specialised blog, commenting on trends in digital currencies – primarily Bitcoin), there are currently about 29 million digital wallets holding at least 0.001 BTC, although some individual users may own multiple wallets.

Although BTC is the most popular digital currency (and the first one to become widely recognisable), it is certainly not the only one. There are currently more than 400 recognisable cryptocurrencies traded in special digital exchanges (twice this number if you count smaller, less successful ones) with a total capitalisation of $700 billion at its peak (January 3, 2018) – although since then the market has lost a significant part of this value (but it’s still worth 100s of billion of US dollars).

If you have heard about Bitcoin before, chances are you first searched for it sometime between December 2017 and January 2018; that is when the value of Bitcoin soared to $20 000 a piece. A search on Google Trends (a Google utility that shows how many people have searched over a period of time for a certain term – in this case “Bitcoin”) shows this very clearly.

So what do people do with Bitcoin and other cryptocurrencies? The truth is that the majority of users use them for speculative purposes: they buy and sell them, in the hope of making a profit. Due to its extreme volatility (it is very common for the price of the larger cryptocurrencies to fluctuate by 10–20% daily) and the unregulated nature of the cryptocurrency market, it is hardly surprising that most users treat them as very high-risk commodity. This is also why digital currencies tend to attract attention (and new users) when their price soars.

However, cryptocurrencies are not only used for speculation. They can also be used to facilitate transactions. Indeed, according to Wikipedia, there are currently more than 100 000 merchants accepting BTC as a form of payment (online or offline with wallet readers). Financial technology (‘Fintech’) is catching up with this market and some new companies try to compete with the traditional payment networks (Mastercard, Visa and others) by launching plastic cards linked with crypto-wallets (primarily Bitcoin).

Santander bank has expressed an interest in exploring this market further. It is certain that if the market for cryptocurrencies keeps growing at this pace, there will be a lot more challenger fintech firms launching new products that will make it easier to use digital currencies in everyday life.

Cryptocurrencies, therefore, are likely to have a significant impact on the way we pay for our transactions. They can be used to lower transaction costs (e.g. by simplifying the process of sending money abroad), speed up the processing of payments, facilitate microfinancing and transactions in some of the poorest places on earth – where the closest bank may be 50 miles away or further from where people live).

But there is a dark side to these products. They have been linked to tax-evasion for instance, as many people who trade digital currencies fail to declare capital gains to national tax authorities. They can be used to overcome capital controls and other restrictions imposed by national governments (the case of Greece comes to mind as a recent example).

They have also been blamed for facilitating illegal trading activities, such as in drugs and weapons, due to the anonymity that some of these coins are thought to offer to their users – although quite often they are much easier to trace than their users believe.

Cryptocurrencies do have the potential to change the way we live. They also have the potential to become the biggest Ponzi scheme in the history of mankind.

Over the next few months, I will write a number of blogs to explore the literature on the economics of cryptocurrencies, and discuss some of the major challenges that needs to be overcome if this technology is to become mainstream.

Articles and information

Questions

  1. How much do you know about Bitcoin and other cryptocurrencies? When did you first find out about them and what triggered your interest?
  2. Would you be willing to accept payment in BTC? Why yes? Why no?
  3. Identify five ways in which the use of cryptocurrencies can benefit or damage the global economy.

On 15 January 2018, Carillion went into liquidation. It was a major construction, civil engineering and facilities management company in the UK and was involved in a large number of public- and private-sector projects. Many of these were as a partner in a joint venture with other companies.

It was the second largest supplier of construction and maintenance services to Network Rail, including HS2. It was also involved in the building of hospitals, including the new Royal Liverpool University Hospital and Midland Metropolitan Hospital in Smethwick. It also provided maintenance, cleaning and catering services for many schools, universities, hospitals, prisons, government departments and local authorities. In addition it was involved in many private-sector projects.

Much of the work on the projects awarded to Carillion was then outsourced to other companies, many of which are small construction, maintenance, equipment and service companies. A large number of these may themselves be forced to close as projects cease and many bills remain unpaid.

Many of the public-sector projects in which Carillion was involved were awarded under the Public Finance Initiative (PFI). Under the scheme, the government or local authority decides the service it requires, and then seeks tenders from the private sector for designing, building, financing and running projects to provide these services. The capital costs are borne by the private sector, but then, if the provision of the service is not self-financing, the public sector pays the private firm for providing it. Thus, instead of the public sector being an owner of assets and provider or services, it is merely an enabler, buying services from the private sector. The system is known as a Public Private Partnership.

Clearly, there are immediate benefits to the public finances from using private, rather than public, funds to finance a project. Later, however, there is potentially an extra burden of having to buy the services from the private provider at a price that includes an element for profit. What is hoped is that the costs to the taxpayer of these profits will be more than offset by gains in efficiency.

Critics, however, claim that PFI projects have resulted in poorer quality of provision and that cost control has often been inadequate, resulting in a higher burden for the taxpayer in the long term. What is more, many of the projects have turned out to be highly profitable, suggesting that the terms of the original contracts were too lax.

There was some modification to the PFI process in 2012 with the launching of the government’s modified PFI scheme, dubbed PF2. Most of the changes were relatively minor, but the government would act as a minority public equity co-investor in PF2 projects, with the public sector taking stakes of up to 49 per cent in individual private finance projects and appointing a director to the boards of each project. This, it was hoped, would give the government greater oversight of projects.

With the demise of Carillion, there has been considerable debate over outsourcing by the government to the private sector and of PFI in particular. Is PFI the best model for funding public-sector investment and the running of services in the public sector?

On 18 January 2018, the National Audit Office published an assessment of PFI and PF2. The report stated that there are currently 716 PFI and PF2 projects either under construction or in operation, with a total capital value of £59.4 billion. In recent years, however, ‘the government’s use of the PFI and PF2 models has slowed significantly, reducing from, on average, 55 deals each year in the five years to 2007-08 to only one in 2016-17.’

Should the government have closer oversight of private providers? The government has been criticised for not heeding profit warnings by Carillion and continuing to award it contracts.

Should the whole system of outsourcing and PFI be rethought? Should more construction and services be brought ‘in-house’ and directly provided by the public-sector organisation, or at least managed directly by it with a direct relationship with private-sector providers? The articles below consider these issues.

Articles

Carillion collapse: How can one of the Government’s biggest contractors go bust? Independent, Ben Chu (15/1/18)
The main unanswered questions raised by Carillion’s collapse The Telegraph, Jon Yeomans (15/1/18)
Carillion taskforce to help small firms hit by outsourcer’s collapse The Telegraph, Rhiannon Curry (18/1/18)
Carillion Q&A: The consequences of collapse and what the government should do next The Conversation, John Colley (17/1/18)
UK finance watchdog exposes lost PFI billions Financial Times, Henry Mance and George Parker (17/1/18)
PFI not ‘fit for purpose’, says UK provider Financial Times, Gill Plimmer and Jonathan Ford (6/11/17)
Revealed: The £200bn Cost Of ‘Wasteful’ PFI Contracts Huffington Post, George Bowden (18/1/18)
U.K. Spends $14 Billion Per Year on Carillion-Style Projects Bloomberg, Alex Morales (18/1/18)
Carillion may have gone bust, but outsourcing is a powerful public good The Guardian, John McTernan (17/1/18)
PFI deals ‘costing taxpayers billions’ BBC News (18/1/18)
Taxpayers will need to pay £200bn PFI bill, says Watchdog ITV News (18/1/18)
The PFI bosses fleeced us all. Now watch them walk away The Guardian, George Monbiot (16/1/18)
Carillion’s collapse shows that we need an urgent review of outsourcing The Guardian, David Walker (16/1/18)
Carillion collapse: What next for public services? LocalGov, Jos Creese (16/1/18)
Taxpayers to foot £200bn bill for PFI contracts – audit office The Guardian, Rajeev Syal (18/1/18)

Official publications

A new approach to public private partnerships HM Treasury (December 2012)
Private Finance Initiative and Private Finance 2 projects: 2016 summary data GOV.UK
PFI and PF2 National Audit Office (18/1/18)

Questions

  1. Why did Carillion go into liquidation? Could this have been foreseen?
  2. Identify the projects in which Carillion has been involved.
  3. What has the government proposed to deal with the problems created by Carillion’s liquidation?
  4. What are the advantages and disadvantages of the Private Finance Initiative?
  5. Why have the number and value of new PFI projects declined significantly in recent years?
  6. How might PFI projects be tightened up so as to retain the benefits and minimise the disadvantages of the system?
  7. Why have PFI cost reductions proved difficult to achieve? (See paragraphs 2.7 to 2.17 in the National Audit Office report.)
  8. How would you assess whether PFI deals represent value for money?
  9. What are the arguments for and against public-sector organisations providing services, such as cleaning and catering, directly themselves rather than outsourcing them to private-sector companies?
  10. Does outsourcing reduce risks for the public-sector organisation involved?

With first Houston, then several Caribbean islands and Florida suffering dreadful flooding and destruction from Hurricanes Harvey and Irma, many are questioning whether more should be spent on flood prevention and reducing greenhouse gas emissions. Economists would normally argue that such questions are answered by conducting a cost–benefit analysis.

However, even if the size of the costs and benefits of such policies could be measured, this would not be enough to give the answer. Whether such spending is justified would depend on the social rate of discount. But what the rate should be in cost-benefit analyses is a highly contested issue, especially when the benefits occur a long time in the future.

I you ask the question today, ‘should more have been spent on flood prevention in Houston and Miami?’, the answer would almost certainly be yes, even if the decision had to have been taken many years ago, given the time it takes to plan and construct such defences. But if you asked people, say, 15 years ago whether such expenditure should be undertaken, many would have said no, given that the protection would be provided quite a long time in the future. Also many people back then would doubt that the defences would be necessary and many would not be planning to live there indefinitely.

This is the familiar problem of people valuing costs and benefits in the future less than costs and benefits occurring today. To account for this, costs and benefits in the future are discounted by an annual rate to reduce them to a present value.

But with costs and benefits occurring a long time in the future, especially from measures to reduce carbon emissions, the present value is very sensitive to the rate of discount chosen. But choosing the rate of discount is fraught with difficulties.

Some argue that a social rate of discount should be similar to long-term market rates. But market rates reflect only the current generation’s private preferences. They do not reflect the costs and benefits to future generations. A social rate of discount that did take their interests into account would be much lower and could even be argued to be zero – or negative with a growing population.

Against this, however, has to be set the possibility that future generations will be richer than the current one and will therefore value a dollar (or any other currency) less than today’s generation.

However, it is also likely, if the trend of recent decades is to continue, that economic growth will be largely confined to the rich and that the poor will be little better off, if at all. And it is the poor who often suffer the most from natural disasters. Just look, for example, at the much higher personal devastation suffered from hurricane Irma by the poor on many Caribbean islands compared with those in comparatively wealthy Florida.

A low or zero discount rate would make many environmental projects socially profitable, even though they would not be with a higher rate. The choice of rate is thus crucial to the welfare of future generations who are likely to bear the brunt of climate change.

But just how should the social rate of discount be chosen? The following two articles explore the issue.

Articles

How Much Is the Future Worth? Slate, Will Oremus (1/9/17)
Climate changes the debate: The impact of demographics on long-term discount rates Vox, Eli P Fenichel, Matthew Kotchen and Ethan T Addicott (20/8/17)

Questions

  1. What is meant by the social rate of discount?
  2. Why does the choice of a lower rate of social discount imply a more aggressive climate policy?
  3. How is the distribution of the benefits and costs of measures to reduce carbon emissions between rich and poor relevant in choosing the social rate of discount of such measures?
  4. How is the distribution of the benefits of such measures between current and future generations relevant in choosing the rate?
  5. How is uncertainty about the magnitude of the costs and benefits relevant in choosing the rate?
  6. What is the difference between Stern’s and Nordhaus’ analyses of the choice of social discount rate?
  7. Explain and discuss the ‘mortality-based approach’ to estimating social discount rates.
  8. What are the arguments ‘for economists analysing climate change through the lens of minimising risk, rather than maximizing utility’?