Risk in Public Sector Project Appraisal: It Mostly Does Not Matter!
Public project appraisal using cost-benefit analysis (CBA) requires analysts to project risky net benefits and to convert these into present values using a social discount rate (SDR). We consider which types of risk matter for CBA. For small projects with only idiosyncratic risks, expected net benefits should be discounted at a risk-free SDR. If projects are large or expected net benefits are correlated with aggregate consumption, the alternatives are to replace expected net benefits with their certainty equivalents (CEs) and to discount these at a risk-free SDR, or to discount expected net benefits using a higher SDR that includes a risk premium. These methods are equivalent under special circumstances that are unlikely; the first approach is the correct one. We examine when replacing expected values with CEs will matter, and how this might be done. For most projects, analysts should discount expected values of net benefits at a risk-free SDR.