Optimism bias

The Productivity Commission public inquiry into Public Infrastructure has received its first initial submissions. Number 87 comes from Henry Ergas in his private capacity.

Having done similar things I applaud his eagerness to participate in the process, even though I disagree with almost everything he says. It is, however, pleasing to see him acknowledge that telecommunications networks are a natural monopoly.

The key issue that I wanted to highlight is Ergas comments about discount rates.  He states about large infrastructure projects that;

The discount rates used do not properly incorporate a mark-up for optimism bias and other distortions in public sector decision-making. The extent of that mark-up should reflect the option value of deferring investment, which in turn depends on the extent to which updated cost and demand information could lead to a reconsideration of the timing and extent of investment.

This is a very, very big call.

I first want to talk about "optimism bias." The phenomenon of "optimistic bias" is well researched. One item quoted the following cases;

"People expect to complete personal projects in less time than it actually takes to complete them" (Buehler, Griffin & Ross (1994)) (basis of Hofstadter's Law)

"Students expect to receive higher scores on exams, at least when those exams are still some time away, then they actually receive." (Shepperd, Ouellette and Fernandez (1996))

"Second-year MBA students were found to overestimate the number of job offers they would receive, the magnitude of their starting salary, and how early they would receive their first offer." (Hoch (1985))

Professional financial analysts "were reasonably able to anticipate periods of growth and decline in corporate earnings, but consistently overestimated earnings realised." (Calderon (1993))

Vacationers "anticipate greater enjoyment during upcoming trips than they actually expressed during their trips." (Mitchell, Thompson, Peterson and Cronk (1997))

Newlyweds "almost uniformly expect that their marriages will endure a lifetime" despite the large proportion of marriages that end in divorce. (Baker and Emery (1993))

Students "consistently reported that they would behave in more socially desirable ways - for example, that they would be more resistant to unwanted social influence, or more likely to donate time to a worthy charity - than did people who have not first been asked to make predictions about their behaviour". (Sherman (1980))

"Most people expect they have a better-then-average chance of living long, healthy lives; being successfully employed and happily married; and avoiding a variety of unwanted experiences such as being robbed and assaulted, injured in an automobile accident, or experiencing health problems." (Weinstein (1980))

"Between 85% and 90% of respondents claim that  their future will be better - more pleasant and less painful - than the future of an average peer" (Armor, 2000, unpublished raw data)

Most smokers believe they are less at risk of developing smoking-related diseases than others who smoke. (Weinstein, 1998, unpublished manuscript)

Further analysis reveals that the bias is also described as the "planning fallacy" which Wikipedia credits to the great founders of behavioural and experimental economics - Tversky and Kahneman.

In perhaps a blow to the critics of NBN Co's corporate planning, the bias is subjective, since "The bias only affects predictions about one's own tasks; when uninvolved observers predict task completion times, they show a pessimistic bias, overestimating the time taken."

In the context of infrastructure bias Ergas quotes the oft cited case of Sydney's Cross City Tunnel for which the investors got seriously burned due to overstating demand.

In the futurist business there is a principle referred to as Amara's Law which states "We tend to overestimate the effect of a technology in the short run and underestimate the effect in the long run."  I am not aware of any empirical test for this, but it is consistent with my observations of previous historical predictions. While we all often laugh about the great underestimation quotes like Tom Watson and the world market for computers, look at the average success rate of product forecasts and they over-estimate early sales and under-estimate the long run.

This is certainly the case with most of the road projects. 

In other words the optimism bias in long run projects is a tendency to flatten out the growth curve rather than predict  more normal exponential-like (meaning any of a family of S shaped curves) adoption. 

Ergas solution to the perceived problem of optimism bias is to increase the discount rate. He is reintroducing here a concept called "real option theory" that he tried for years to have incorporated in regulatory proceedings by the ACCC to increase the WACC (discount rate) that should be applied to accessing Telstra infrastructure. This is a weighting supposed to reflect the benefit of waiting to make a decision in the future when there was greater certainty of demand.

One of the difficulties with this approach though is that absent the actual infrastructure there is no way to determine the real demand - the preference for driving on that road or for using that broadband service can only be revealed by having the road or service available.  This is not "build it and they will come" so much as "build it and you will know its use".

But this then brings us to the fact that take-up curves are S-shaped, use promotes further use. If this is the case, and importantly if the optimism bias in the early period of the project is counterbalanced by a pessimism bias in the long run, then the approach of adopting a single higher discount rate is wrong, because it penalises more the forecasts that are further out and more likely to be right.

The correct response to optimism bias isn't a higher discount rate, it is to deal with the sensitivity analysis of the forecasts in both the short and long term. From a finance perspective it certainly means investors should note be financing with a lot of debt financing upfront that immediately requires servicing out of forecast cashflows (which was the real problem for CCT). Ideally you need equity investors who are prepared to be patient in generating a return.

Ultimately that is what makes the case for Government ownership. Only Government can afford to absorb the risk in the short term.

Ergas second point in the paragraph quoted is about "public sector decision making".  This follows from an earlier assertion about the kinds of projects that attract investment; saying;

The incentives in political decision-making lead to an undue emphasis on ‘ribbon cutting’ opportunities, generally associated with very major (‘mega’) projects, at the expense of periodic maintenance and of small-scale ‘de-bottlenecking’ options that could postpone or even avoid the need for costly asset expansions.

This shows a lack of understanding of politics.  The NBN was a great project because it delivered lots of ribbon-cutting (or button pressing) opportunities.  Lots of small projects would actually be more appetising.

But the real problem with this is the arrogance of the techno-crats...that political decision making is somehow less reliable than other forms of analysis. But in the final analysis political decision making is driven by what voters actually want. The technocrats need to not deride the people but get into the explaining business if they genuinely believe the wrong decisions are being made.

It will be interesting to se how much of Mr Ergas own views features in the report of the CBA review of broadband policy.