Identify and Analyse Risks

2.6.4  Risk arises because of the possibility of more than one outcome occurring. This possibility may exist because, for example:

•  construction costs depend on ground conditions, or the weather;

•  operating costs depend on the success of a new technology;

•  the demand for an outcome or output depends on future incomes;

•  there are uncertainties about future wage or fuel costs, or changes in consumers' tastes, or competition from other suppliers.

2.6.5  No matter how robust the assumptions about these and other factors, there will still generally be risks to consider, and there will be uncertainty over the range of possible outcomes.

2.6.6  A distinction may be drawn between a risk, which is measurable and has a known or estimable probability, and an uncertainty, which is vaguer and of unknown probability. In practice, this distinction is not always clear cut however the Option Appraisal Guide uses the term risk in STEP 6 and uncertainty in STEP 8.

2.6.7  Variability, or Variance, is the spread of possible outcomes around an expected outcome. All projects have a range of possible outcomes, although the range will be wider, and variability more important, for some cases than for others. For instance, the range may be wider for cases involving new technology.

2.6.8  In general, for proposals where the benefits and costs accrue to the community as a whole, the cost of variability is so small relative to the margin of error in appraisal or evaluation as to be negligible, and for the public sector may be regarded as Risk Neutral. In other words, decisions should be based on expected outcomes, not their variability.

2.6.9  However, there may be some situations where it is appropriate to take account of variability as well as expected outcomes and be Risk Averse i.e. be inclined to reject certain risky investments despite positive expected outcomes. For instance, this may apply where risk is:-

•  concentrated i.e. where risks are large relative to the income of the section of the population that must bear them; and

•  systematic i.e. where variability is correlated with income e.g. where better outcomes from a project or policy are likely to accrue in good times and worse in bad times.

2.6.10  If a set of circumstances or course of action or inaction could lead to a very adverse outcome, even if with a very small probability, action to avoid that outcome may be appropriate. This is the "precautionary principle". It also applies where the probability attaching to a possible outcome involving significant harm is uncertain. In such circumstances, it may be appropriate to consider precautionary action specifically to mitigate or avoid the risk of the particular outcome. An example would be restrictions on movements of people and cattle during an outbreak of foot and mouth disease.

2.6.11  Where a project or programme risks potentially irreversible consequences (e.g. it would rule out important subsequent investment opportunities or a use of resources that might subsequently be preferred) this should be carefully appraised. Examples of irreversibility are destruction of natural environments or historic buildings.

2.6.12  Some projects expose the government to contingent liabilities - that is commitments to future expenditure if certain events occur. These should be appraised (and monitored if the proposal goes ahead). Scottish Parliament approval is required if the contingent liability created is in excess of £1m. One class of contingent liabilities is the cancellation costs for which the government body may be liable if it terminates a contract prematurely. Such liabilities, and the likelihood of their coming about, must be taken into account in appraising the initial proposal. Redundancy payments fall into this category, but as the wider social and economic consequences of these should also be assessed, advice from Analytical Services should be sought.

2.6.13  A vital first step in the analysis is to identify and analyse the important risks and uncertainties relevant to the case, and to show how they compare under each option. This risk analysis should help inform the adjustments for optimism bias and identification of risk management and reduction measures (see below). It is good practice to summarise the relevant information in tabulation, called a Risk Log or Risk Register, which identifies each relevant risk and compares how it impacts upon each option. This should cover not only the 'economic' risks and uncertainties, such as possible variations in cost/benefit assumptions, but also relevant managerial, legal, financing and other risks and uncertainties. Textual description should be accompanied by quantification where possible.

2.6.14  The Office of Government Commerce (OGC) website provides an example of a risk log and further information on risk identification and management. See http://www.ogc.gov.uk