Optimism Bias in Major Infrastructure Projects Dr Eamonn Molloy Presentation to: International Consulting Economists Association London 18th January 2010

Projected infrastructure spending by region - US$ ’000bn, 2005-2030 9.2 6.5 0.9 15.9 7.5 1.1 Source: Cohen & Steers Global Infrastructure Report 2009: The $40 Trillion Challenge

Planned UK infrastructure investment 2010 -11 to 2014 - 15 Total 195 Source: HM Treasury, Infrastructure UK (values in 2008-09 prices)

Characteristics of major infrastructure Inherently risky Technology and design often non-standard Decision-making, planning, management are complex Project lock-in or capture at early stage Scope and ambition changes over time Budget and contingencies often inadequate Misinformation about costs, benefits and risks is the norm, including business case Cost overrun and benefit shortfalls during implementation

Inaccuracy of transportation project cost estimates by type of project (in constant prices) No. of cases Avg. cost overrun % Standard deviation Rail 58 44.7 38.4 Bridges & Tunnels 33 33.8 62.4 Road 167 20.4 29.9 For transportation mega-projects… 9 out of 10 projects have cost overrun Overrun is found across 20 nations and 5 continents Overrun is constant for the 70-year period of the study Cost estimates have not improved over time Source: Flyvbjerg, 2007

Inaccuracy of forecasts of rail passenger and road vehicle traffic Type of project No. of cases Avg. error % Std dev Rail 25 -51.4 28.1 Road 183 9.5 44.3 84% of rail passenger forecasts are wrong by > +/- 20% 9/10 rail projects overestimate traffic 50% of road traffic forecasts are wrong by > +/- 20% No. of roads with overestimated and underestimated traffic is about the same Inaccuracies are global Inaccuracies are constant over last 30 years Source: Flyvbjerg, 2007

Why is this a problem? Cost overruns and benefit shortfalls are a problem because: Leads to a pareto-inefficient allocation of resources, i.e. waste Leads to delays and further cost overruns and benefits shortfalls They destabilize project management The problem is getting bigger because projects are getting bigger

Garbage in = Garbage out Example: Channel Tunnel Longest underwater rail tunnel in Europe, connecting France and UK At IPO, Eurotunnel told investors: “10% would be a reasonable allowance for the possible impact of unforeseen circumstances on construction costs.” Actually… 80% over construction costs, 140% over for financing. Revenues half of those forecast, IRR at -14.5% Economy would have been better off if the Tunnel was never constructed Solution: Fire the forecasters?

Explanation 1: Technical Imperfect forecasting techniques Inadequate data Honest mistakes Inherent uncertainty in predicting the future Lack of skills, knowledge, experience of forecasters Solution: develop better forecast models, better data, training forecasters and PM’s.

Explanation 2: Psychological: Planning Fallacy and Optimism Bias Managers make decisions based on delusional optimism rather than rational weighting of gains, losses and probabilities Overestimate benefits and underestimate costs Spin scenarios of success and avoid considering potential mistakes and miscalculations Ubiquitous cognitive bias Solution: Simple reality checks

Explanation 3: Political Economic Planners and promoters deliberately and strategically overestimate benefits and underestimate costs This increases the likelihood that their projects, not competitors will be selected Emphasize success scenarios and downplay failure scenarios Lying and corruption pays off… Solution: Accountability

Survival of the Un-fittest… underestimated costs overestimated benefits + = funding

The Outside View: Reference Class Forecasting Identify a relevant reference class of past projects Broad enough to be statistically relevant, narrow enough to be directly comparable Establish a probability distribution for the selected reference class Needs credible, reliable data Compare project with reference class distribution Establish most likely outcome for the project Source: Flyvbjerg and Cowi, 2004  

Inaccuracy of construction cost forecasts for rail projects in reference class. Source: Flyvbjerg, 2007

Example: Edinburgh Tram Line 2 (2004) Initial cost estimate of £320M made by planners was adjusted for optimism bias and acceptable risk using a probability distribution. Resulted in revised cost estimate of £400M Included contingencies to insure against cost overruns at the 80% level (i.e., 20% risk of cost overrun) If Scottish Parliament accepted a 50% risk of overrun then cost estimate including contingencies could be lowered to £357M Approach now being applied on other projects, e.g., Crossrail London, estimated £16 Billion.

Summary Major Infrastructure / Mega Project spending set to increase globally Effective delivery is crucial – failure has major economic consequences Optimism bias and Strategic misrepresentation a significant contributory factor in overestimation of benefits and underestimation of costs Reference class forecasting and the outside view can mitigate this when supported by appropriate governance and accountability

Thankyou eamonn.molloy@pmb.ox.ac.uk