Introduction
In this week’s column I start with a wrap-up of the discussion on uncertainty and risk as applied to government projects and then go on to offer brief comments on the notion: time is money. As I have already noted the track record of Guyana’s public projects indicates there is considerable wastage, gross mismanagement, and an awful absence of transparency in the selection, design, execution, implementation, monitoring and auditing of these.
Government projects have been all too often executed as if the public resources involved in them are the private properties of the ruling party/ government and its cabal of insiders. The list of troubled projects that exhibit significant cost overruns, weak execution, delays in implementation, poor quality, and manifest corruption is so formidable, it can no longer be hidden from public scrutiny despite I might say, the best efforts of the Authorities to do this. This treatment of public projects as the private properties of the Authorities constitutes the core defect of government decision-making and spending in Guyana.
Corollaries
A corollary of this observation is that management of these projects routinely fails to distinguish between what economists term as the “known-unknowns” and the “unknown-unknowns”. As I noted before, knowledge of this distinction is essential for systematic thinking and the application of best practice methods to public projects. Another corollary requires readers to bear in mind the difference between risk and uncertainty discussed before. Like others, I believe that the best way to appreciate project risk is to interpret it as encompassing responses to three questions:
What can go wrong in a project?
How likely is this to occur? (Or, what is the probability of things going wrong for the project)
What are the consequences for project viability, if things do go wrong? (Or, how serious is the impact on the project if things went wrong?
These two corollaries lead to three axioms. First, project risk is not the same as project uncertainty. The two are quite distinct regions of indeterminacy or unsureness. Second, if there is no project uncertainty, then there can be no project risk. The basic logic of this is that if one can be certain of the future, then there is by definition no risk. Third, the greater the uncertainty of a project, the higher is the degree of risk that project embraces.
Characteristics of Risk
From this discussion, the following characteristics of project risk arise: 1) The greater is the project risk, the greater should be the expected returns. 2) Embracing project risks in the absence of expected returns is economic “suicide” 3) Project risks can be minimized through precautionary action, but risks cannot be entirely eliminated 4) Following on (1) – (3), Risk should be managed so as to minimize it. Indeed this is the basis for the emergence of insurance firms specializing in the area of risk.
Finally, social benefit-cost typically classifies risks into eight (8) broad types, namely: Market Risk, Credit Risk, Liquidity Risk, Operational Risk, Legal and Regulatory Risk, Business Risk, Strategic Risk, and Reputational Risk.
Discounting: Time is Money
My consideration of time is money here stems from the likelihood that investments in the construction phase of projects will occur upfront; (this phase may take from weeks to years). Generally, however, it is only after construction is completed and the investment goes into operation (sometimes lasting for many future years) the project incurs production costs and also generates benefits to cover these costs and provides payback (including profit) for the investment made upfront. Because this occurs in the future, project evaluation has to incorporate the fact that a dollar in the future is worth less than a dollar today.
Why is this so? Put at its simplest, money invested in a project today can alternately be put into a bank and earn interest so that in future years the amount of money becomes larger. This would depend on the rate of interest.
This basic principle is not only important to project analysis; it underlines all economic decisions involving actions, which occur over long periods. There is a simple ready-made formula that indicates how much less a dollar in the future is worth, compared to a dollar today. It is called the discounted present value formula. Further, the process of translating a future payment into a present value or current worth is called discounting.
Let us consider an example of this: A year from today a present value of $100,000, earning at 10 percent interest annually, would be worth $110,000. From this it follows (other things being equal), one would treat $110,000 a year from now as the equivalent of $100,000 today (that is, its present value or current worth). Simply put, in this example the discount rate is 10 percent or the expected rate of return (rate of interest) paid on money into the future.
We can say therefore, money in the future must be discounted to determine its present value. More generally, in social cost benefit-analysis, future flows of project costs and benefits would have to be discounted to determine their present values or current worth. The level of the discount rate therefore, has a tremendous bearing on this outcome of translating future flows into their present value or current worth.
As a rule, the higher is the discount rate the lower is the present value of future cash flows. This circumstance makes the determination of the appropriate discount rate used in feasibility studies of government projects, a critical determinant of the viability of these studies.
Conclusion
This concludes my comments on “risk and uncertainty” and “time is money”. In coming weeks I shall morph this discussion of feasibility studies and the appraisal of government projects into a broader analysis of systematic thinking in government economic decision-making and investment spending as evidenced in the Guyana National Budget 2013 and the many troubled projects, of which we are all aware.
