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Issue 5/11 March 2009

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Today’s Issue Includes:


1) Should there be a third runway at Heathrow? Stephen Romer examines the arguments and looks at the cost benefit analysis

stephen_romerThe biggest transport-related debate in 2008 was about the proposal to build a 2,200 metre-long third runway (and accompanying sixth terminal) at Heathrow. From an environmental point of view the third runway project was an anathema, a curse which would render the government’s greenhouse gas-reduction policy meaningless. A government decision in favour of the third runway would be an environmental catastrophe. It would persuade people that the previous political posturing of politicians’ pious pollution policy was pure piffle.

But for the airport lobby (BAA, the airlines, the CBI and big business generally), the expansion of Heathrow was long overdue. Growth in passenger airport use has pushed airports to capacity. Heathrow in particular has been operating at 99% capacity in recent years – it must be expanded. And the urgency is emphasised if the UK’s main airport is going to retain its status as Europe’s most important hub at a time when the airports of Amsterdam, Paris and Frankfurt are becoming an increasing competitive threat. The third runway is the answer: the extra capacity will allow annual passenger numbers to rise by 16 million to 82 million.

runway_400In January 2009, the government gave BAA the permission it sought to make an application for planning permission. In expanding Heathrow, BAA seeks to spend £8 billion on – in effect – adding to Heathrow a second airport roughly the size of Gatwick. 700 houses in the village of Sipson will be demolished to make way for the runway, and noise and air pollution will be vastly increased as a result of the thousands of additional take-offs and landings.

The third runway policy is hugely controversial within the government itself, and several Cabinet ministers are opposed to the project (should they resign now the green light has been given?). To appease critics, Geoff Hoon, the Transport Secretary, spun third runway policy as follows: the environmental costs will be contained by regulating the extent to which the new runway can be used. Specifically, only aircraft meeting exacting emissions standards will be allowed to use it, and the runway will operate only at half capacity until 2020.

Moreover, total UK aviation emissions will be no higher than the 2005 levels
(37.5 million tonnes) by 2050. This pledge will be regulated by the new Climate Change Committee, an independent body which will be able to reduce runway use if the emissions standards are not being met.

Hoping to heal the horrors of the Heathrow haters, Hoon also proposed a new railway station at Heathrow: at an investment cost in excess of £5 billion, the UK’s second high speed line, HS2 (HS1 is the St. Pancras-Channel Tunnel route, opened in 2007) will run from Heathrow to Birmingham. Other railway lines will be electrified, cutting down on the use of relatively heavily polluting diesel-powered locomotives.

Cost Benefit Analysis
Where you have a major infrastructure project such as the expansion of Heathrow, there is usually a dispute about whether it is in the public interest to go ahead with the project – or whether the costs (including externalities) outweigh the benefits and therefore it is in the public interest for the project to be cancelled.
In these circumstances, it is traditional for economists to use Cost Benefit Analysis (CBA), a technique which calls for the pricing of the widest possible account of all of the economic consequences, both negative and positive, arising from the project. CBA has a somewhat old fashioned image, its heyday being in the pre-thatcherite era when the public sector was a clearly separate entity from the private sector – an era in which the objective of public sector organisations could be stated quite unambiguously as the maximisation of net social benefit.

Today, 30 years of privatisation has blurred these distinctions. But what was interesting about the third runway project was that the Department of Transport did indeed use CBA to evaluate the Heathrow expansion. Its conclusion was that a net benefit of £47 million per annum would be attributable to the third runway. The main benefits: the increase in employment (both during construction and subsequent operation), and the local multiplier effect. There would also be benefits arising from an assumed boost to business activity and increases in foreign tourist numbers.

But a CBA of this sort is inevitably controversial. In the first place, a net annual gain of £47 million is relatively small. It implies that the positive conclusion of the CBA analysis is not robust – it is highly sensitive to a worsening of any one of numerous assumptions that underlie the study.

But the most interesting thing about CBA is that there is invariably a major question mark about how to quantify purely qualitative aspects of the analysis. The third runway will increase the number of flights at Heathrow by about 350 every day, including many night flights. Therefore, one of the major costs of the airport expansion is noise pollution on the ground. It’s one of the reasons why the third runway has met such strong opposition. But how do you put a monetary value on, say, the loss of a full night’s sleep for 200,000 people newly affected by aircraft noise? And even where there are more tangible costs in CBA analysis, there is often scope for debate. We know that from 2012, the aviation sector will be incorporated in the EU Emissions Trading Scheme, thus we must make an assumption about the price in the future of the additional pollution permits that the third runway will necessitate purchasing. However, for its critics, the Department of Transport’s CBA analysis assumed an unrealistically low price.

Will the third runway eventually be built? In early 2009, it was too early to say. The planning enquiry and legal challenges will run for years, and the environmental activists (who have bought some of the third runway land) will be formidable opponents.

What’s more, the Conservative Party is opposed to Heathrow expansion. Thus the project could be halted shortly after the next General Election. There are several marginal Parliamentary constituencies which would suffer the noise and congestion consequences of the third runway, almost all of which were held by Labour or the Liberals in the anti-Tory landslide of 1997. If he is to form a government, Mr Cameron will have to hang on to these seats.

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2) Green Bananas and the credit crunch. Nigel Tree takes a look at why the financial system failed us.

nigelcropforezineSomeone said to me the other day that you know you are getting old when you need to decide whether it is worthwhile buying green bananas. Well, I am old enough to remember back to when the government and the Bank of England maintained strict control of the banks, with the requirement for them to maintain a cash ratio of 8% of deposit liabilities and a liquidity ratio of 30%. These rules made for binding constraints on the banks’ ability to grow their balance sheet.

However, the climate changed in the early 1970s with preferences for market solutions which together with the growing complexity of financial markets and the abolition of exchange controls in 1979 saw a gradual removal of any cash or liquidity ratios. The Bank of England’s role evolved to be one largely of using interest rates to maintain monetary policy and to maintain a supervisory role over the banks.

This allowed banks to run their own risk assessments as to the assets and liabilities on their balance sheets and it can be argued that it was the failure of this self-supervision that has got us into the financial peril which we are now experiencing.

I want to share with you a brilliant article by Andrew Haldane, Executive Director for Financial Stability at the Bank of England which was published last month. The article is entitled “Why Banks Failed the Stress Test” and took me back to my Economics Statistics class at university. Having said that, although there is a small amount of mathematics in the article, it is superbly written, humorous in parts and easy enough for students to understand.

Andrew Haldane argues that the risk management models used by the banks were wrong. “They failed Keynes’ test – that it is better to be roughly right than precisely wrong. With hindsight these models were both very precise and very wrong.”

He explains that there was a Golden Decade in financial markets between October 1998 and June 2007, with banks’ share prices growing by nearly 60% and their balance sheets rising more than threefold. However, the sub-prime market led to the collapse of asset prices and “estimated losses within the financial sector since the start of the crisis lie anywhere between a large number and an unthinkably large one.”

He then diagnoses the market failures which contributed to the boom and subsequent bust into three categories.

  • Disaster Myopia. He describes this as agents’ propensity to underestimate the probability of adverse outcomes. For example, there is a tendency for drivers to slow down having witnessed an accident and then speed up once the accident has become more distant in their memory. This is similar to what happened in the Golden Decade as stress-tests and risk assessments became increasingly influenced by this period of stability. This resulted in the prices of risk being set too low which in turn helped sow the seeds of the credit boom.
  • Network Externalities. He notes that both within and between financial institutions there are many links and interconnections. When assessing risk “it is not enough to know your counterparty; you need to know your counterparty’s counterparty too. In other words there are network externalities.” He goes on to say that there is evidence that firms find aggregation of risks across their balance sheet extremely difficult to execute. This led to an informational failure and if this is not easily rectified by the actions of individual firms then there is a case for the authorities attempting to provide that missing informational good, however difficult that might be in practice.
  • Misaligned Incentives. Here he says there was a principal-agent problem both internally within financial firms and externally between financial firms and the authorities. Inside firms there is conflict between the risk-managers and the risk-takers and as returns become high the risk-takers gain more power. This is then amplified across the whole financial system as firms compete with rivals for ever higher returns on equity. The second problem is between firms and the authorities. If a bank owes a small amount it is their problem, a large amount and it is the authorities’ problem.

    He cites the example of one of a series of meetings which the Bank held with financial firms to explore their stress-testing or risk-assessment practices. One invited member said that there was “no incentive for individuals or teams to run severe stress tests and show these to management.” First, because if there was such a severe shock, they would very likely lose their bonus and possibly their jobs. Second, because in that event the authorities would have to step-in anyway to save a bank and others suffering a similar plight!

    He concludes that stress-testing was not being used meaningfully to manage risk. Rather, it was being used to manage regulation. Stress-testing was not so much regulatory arbitrage as regulatory camouflage.


Andrew Haldane also offers a number of solutions in this paper as to how stress testing and regulation could be improved and concludes that: “These measures would not prevent a next time – nor should they – but they might help make risk management roughly right.”

You can download the entire article “Why banks failed the stress test” by Andrew Haldane here.

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