Thursday, February 27, 2003

Risk transfer

From HMT's Green Book The two main causes of optimism bias in estimates of capital costs are: poor definition of the scope and objectives of projects in the business case, due to poor identification of stakeholder requirements, resulting in the omission of costs during project costing; and poor management of projects during implementation, so that schedules are not adhered to and risks are not mitigated. Appraisers should adjust for optimism bias in the estimates of capital costs in the following way: Estimate the capital costs of each option; Apply adjustments to these estimates, based on the best available empirical evidence relevant to the stage of the appraisal; and Subsequently, reduce these adjustments according to the extent of confidence in the capital costs' estimates, the extent of management of generic risks, and the extent of work undertaken to identify and mitigate project specific risks. Departments or agencies may be able to provide the best empirical evidence to support adjustments for optimism. Alternatively, and if applicable, they may be taken from the Green Book, which provides the recommended adjustments to be made at the outline business case stage for buildings, civil engineering, equipment and development, and outsourcing projects. If no obvious empirical evidence is available, this may indicate that the project is unique or unusual, in which case optimism bias is likely to be high. In these cases, adjustments should be based on the nearest equivalent project type, and adjusted up or down, depending on how inherently risky the project is compared to its nearest equivalent type. If a department chooses to apply its own adjustments, these must be prudent. Where possible, the cost estimates, and the adjustments for optimism bias should be reviewed externally (using Gateway reviews for large projects, or internal audit reviews of smaller projects).

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