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Adjusting for Optimism Bias

2.6.15There is a demonstrated, systematic tendency for project appraisers to be overly optimistic. This is a worldwide phenomenon that affects both the private and the public sectors. Many project parameters are affected by optimism; appraisers tend to overstate benefits and understate timescales and costs, both capital and operational. It may occur, for example, through failing to reflect fully the chances of cost underestimation or time overruns; or by including projections of demand that are too generous.
2.6.16To redress this tendency, appraisers should make explicit adjustments and thus determine a suitably optimism bias-adjusted NPV for each option. These adjustments will have the effect of increasing the cost estimates, decreasing the projected benefits and extending the timescales over which the costs and benefits are assumed to accrue, compared to the initial unadjusted estimates for each option.
2.6.17NI Departments should follow the guidance in Annex 4 of the Green Book on how to deal with optimism bias in relation to capital works, works duration, operating costs, and under-delivery of benefits; and on how to prevent or minimise optimism bias. Further HM Treasury guidance, including adjustment percentages for generic project categories based on a study by Mott MacDonald, is given in 'Supplementary guidance on the treatment of optimism bias' on the HMT website.
2.6.18The principles in Annex 4 of the Green Book (p.79-90 of document) and in the HMT supplementary guidance should be applied with proportionate effort in a manner that suits the circumstances of NI Departments. Wherever possible, the relevant adjustments should reflect local experience in preference to use of the HMT generic figures. They should be based on data from past projects or similar projects elsewhere, and adjusted for the unique characteristics of the project in hand. When such information is not available, Departments are encouraged to collect data to inform their estimates of optimism, and in the meantime use the best available data.
2.6.19

In any case, Departments should be satisfied that the adjustments made are realistic and justifiable in relation to local experience. They should represent a meaningful effort to improve the quality of assumptions rather than arbitrary percentage adjustments.

Adjusting for Optimism Bias Step-by-Step
2.6.20

The HM Treasury supplementary guidance provides recommended adjustment ranges and advocates a 5-step approach to adjustment:

  1. Decide which project type(s) to use eg Is it a building or civil engineering project? Is it 'standard' or 'non-standard'?
  2. Always start with the upper bound ie select the appropriate upper value from the recommended range of adjustments.
  3. Consider whether the optimism bias factor can be reduced according to the extent to which the contributory factors have been managed and mitigated.
  4. Apply the optimism bias factor ie multiply the relevant cost or benefit estimate by the OB factor and add the result to the estimate.
  5. Review the optimism bias adjustment and reduce it where this is justified by further mitigation of contributory factors.

See the HM Treasury Supplementary Guidance on Optimism Bias for a detailed explanation of these steps including worked examples.
2.6.21Adjustment for optimism bias is a relatively new concept but from experience to date a number of issues arise. Firstly, the application of adjustment factors should not be a one-off event in the life of a project. In fact it should be regarded simply as a starting point for dealing with appraisal optimism. As a project proceeds, risk management should be applied to mitigate factors identified as contributing to appraisal optimism, allowing the adjustment factors to be amended accordingly. Thus the optimism bias-adjusted (or "OB-adjusted") NPV for each option should be refined over time.
2.6.22It follows that business cases should show evidence of progressive reduction in the adjustments made for optimism bias. In general, the allowances for optimism bias should be largest in a high-level business case (for instance a Strategic Outline Case), smaller in a more detailed business case (such as an Outline Business Case), and smallest in a fully developed business case (a Full Business Case). Large allowances for optimism bias will not normally be acceptable in a Full Business Case. If optimism bias remains high at Full Business Case stage, approval may be withheld pending further research, costing and risk management.
2.6.23It is plausible that some high-level business cases might have fairly low allowances for optimism bias, where for instance there is a long track record of successful projects (say, if building the 8th of 10 standard workspace units) or if the project is concerned with off-the-shelf products or where there are published prices (e.g. buying a fleet of cars or vans).
2.6.24Optimism bias must be assessed individually for each option. Different options can be expected to be subject to different risks and as a result different levels of optimism bias. For example, accommodation options involving new build on an unidentified site will have different risk factors than options involving, say, new build on a known site, refurbishment, rent and fit-out, purchase and fit-out, or temporary accommodation.
2.6.25Double counting of risk allowances, by including both an optimism bias adjustment and a contingency allowance to cover the same risk, should be avoided. For instance, optimism bias adjustments should normally be applied to capital costs excluding contingency allowances.
2.6.26Optimism bias adjustments should be used only to allow for underestimates of costs and time, and overestimates of benefits. They should not be used to allow for enhancements to the project scope or output specification.
2.6.27Where costs consist mostly of revenue costs (for instance, staff costs) and capital expenditure is low in both absolute terms and relative to the NPC thenthere may be little value in adjusting costs for optimism bias. However, in such cases the appraisal should state the rationale behind any decision not to adjust for optimism bias to demonstrate that it has at least been considered. This would not affect the need to consider optimism bias adjustments for project duration and benefit shortfall.
2.6.28Some costs and other assumptions may not be amenable to adjustment for optimism bias because the uncertainty surrounding them is due more to market conditions or the general economic climate than optimism. For example, rents assessed by LPS are based upon current market conditions but rents may go up or down in the future due to demand and supply in the market. Such assumptions should be tested using sensitivity analysis (see STEP 8 below).
2.6.29The funding provision for a project including contingency allowances should be sufficient to cover expenditure after adjustment for optimism bias. As optimism bias adjustments are reviewed and reduced during the development of a business case, the corresponding estimates of required funding should be revised accordingly.
2.6.30Business cases should demonstrate that optimism bias has been considered and that appropriate adjustments have been made. Full details of the adjustments made including all calculations should be shown. Where optimism bias adjustments are reduced on account of mitigation of contributory factors, the reductions should be explained and clear evidence supporting the mitigations should be provided.

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