Economic Analysis ofPublic Sector Project

Dr. Wimolpat Bumbudsanpharoke Khamkanya

Outlines

Keywords

Steps of Cost Benefit Analysis

Case study

Keywords

Welfare Economics

1. Principally concerned with defining

economic efficiency

2. Evaluating economic efficiency of resource

allocation

3. Analysing the conditions social welfare

Production Possibility Curve

?

?

Trade - off

A situation that involves losing one quality or

aspect of something in return for gaining another

quality or aspect.

Stocks BondsRiskier, greater return Safer, lower returns

VS.

Opportunity cost

"What you would have done if you didn't make the choice that you did"

.

go to the movies stay home

and watch

the baseball game on TV

go out for coffee with friends

Ticket of $ 100

e. Bill of $ 10

Coffee of $ 50

Cost Benefit Analysis

With vs. Without

With – and – Without Approach => Heart of CBA

1990 1995 2000

Pollution control

project

Project evaluation

Total pollution: 100T

Before

Total pollution: either 50 T or 150T

After

Maybe without project:

Total pollution: 200T

Good overviews of CBA: Paul Portney*; Matthew Kotchen**.

Portney: “it is an attempt to identify and express in dollar terms all

of the effects of proposed government policies or projects”

It is a useful tool to assess the social welfare impacts of a project or

policy.

Many economists favor using it when assessing a project – though it

still raises concerns in many quarters and can be difficult to get

right.

•See: Paul R. Portney, "Benefit-Cost Analysis." The Concise Encyclopedia of Economics. 2008. Library of Economics and Liberty. 4 September 2013. <http://www.econlib.org/library/Enc/BenefitCostAnalysis.html>.** Kotchen, Matthew J., “Cost Benefit Analysis”, Encyclopedia of Climate and Weather 2nd Edition, Stephen Schneider(ed.), New York: Oxford University Press, 2010. <http://environment.yale.edu/kotchen/pubs/CBAchap.pdf>.

Cost Benefit Analysis:

What is it?

“it is a systematic process that is used to calculate and

compare the costs and benefits of a project, decision or

government policy, and determine the positive or

negative outcomes of a planned action over a period of

time”

Cost Benefit Analysis:

What is it?

costs

benefits

Step-by-step CBA

Step 1: Define the referent group.

Step 2: Select the portfolio of alternative project formulation.

Step 3: Catalogue all potential physical impacts of the project.

Step 5: Predict quantitative impacts over the life of the project.

Step 6: Monetize impacts.

Step 7: Discount to find present value of costs and benefits.

Step 8: Sum: add up benefits and costs.

Step 9: Perform sensitivity analysis.

Step 10: Make a recommendation.

Step 4: Define what would happen without the project.

Define the referent group

Step 1

Q2: Who do you include in your analysis?

Whose costs and benefits?

Q1: What is the scope of the analysis?

Should it be local? Provincial? National? Global?

Geographical scoping:

Setting the boundaries / Where to stop?

Stakeholders scoping:

whose costs and benefits to include in the analysis?

How about river diversion from one country to

another?

How about air pollution emitted by one country and

impacting another country (e.g. sulfur dioxide

emissions from USA)?

How about a hydro-power project in China

impacting the flow of the Mekong River in Thailand

and Cambodia?

Geographical scoping

Referent group

Local

community

Other local

communities within the

state

Other states in the

country

Other

countries

Select the portfolio of alternative project formulation.

Step 2

Possible alternatives,

but which one to choose?

Water supply project

Difficulties:

It is impossible to define ALL possible alternative project formulations

Thus,

Only a limited number of options will be analysed

Step 3

Catalogue all potential

physical impacts

This is perhaps the most important and most common failure in CBA.

Meaning: List ALL impacts of the projects, including

the required inputs of the project (e.g.

labor, capital, etc.), and the outputs of the

project.

Energy options Water SupplySedimentation

Hydropower for

electricity

Maintenance or

Decommissioning

Recreation

Greenhouse Gas Emissions

(from flooded vegetation)

Flooded habitats

culture and homes

Displaced People Protest

Licensing issuesSalinity

Waterlogging

Loss of

Livelihood from

fisheries

Food

from

irrigation

Trans-boundary

water competition

Loss of

Downstream

Aquifers

River Bank

Erosion

Environmental

Flow

Requirement

Potential Issues Arising From Dam Construction

Source: The World Commission on Dams (2000)

Difficulties:

• Many of the impacts may not be known;

• Science is incomplete and often can be

contradictory.

Define what would happen without the project

Step 4

Tourist jetties in Malaysia

Purpose of the project: To increase tourism on the islands

“This region has been identified for tourism development…”

“The jetties will boost the economy of the islands…”

“(…) designed to encourage the tourism industry.”

“(…) it is also the wish of the Ministry to increase the influx of visitors…”

No – project option:

• No increment of income to the State;

• Noise levels remain the same;

• Existing air quality maintains;

• Marine water quality remains the same;

• No change in aesthetic value;

• Socio-economy of the area remains the same;

• Ecology of the area remains the same.

Tourist jetties in Malaysia•

We must always ask:

What would happen if

the project does not

take place. We must

compare how the

situation will be “with

the project” and how it

is expected to be

“without the project”.

Number of

tourists

2500

2004 2005 2006 2007 2008 2009 2010 2011 etc…

Without project

Jetties ready With project

Impact of the

project

Existing #

of tourists

Tourist jetties in Malaysia

Step 5

Predict quantitative impacts over the life of the project.

Vorotan tunnel to supply water to lake sevan,

Armenia

Construction of tunnel

Conversion of pumps

Increased fisheries

Relocation of population

Increased amenity value

How many km? What technology?

How many pumps?

What is now? How much more?

How many? Relocate where?

What are you talking about?

Step 1: Define the referent group. Who has standing?

Step 2: Select the portfolio of alternative project formulation.

Step 3: Catalogue all potential physical impacts of the project.

Step 5: Predict quantitative impacts over the life of the project.

Step 6: Monetize impacts.

Step 7: Discount to find present value of costs and benefits.

Step 8: Sum: add up benefits and costs.

Step 9: Perform sensitivity analysis.

Step 10: Make a recommendation.

Step 4: Define what would happen without the project.

NOT ECONOMICS:

ECONOMICS:

NEED MULTI-DISCIPLINARY TEAM

Step-by-step CBA

Step 6

Monetize impacts.

Market vs. Non market Goods

Trade

Price

Value

Most environmental goods and services,

such as clean air and water, and healthy fish

and wildlife populations, are not traded in

markets.

Their economic VALUE - how much people would

be willing to pay for them- is not revealed in market

prices.

The only option for assigning monetary values to

them is to rely on non-market valuation methods.

Step 7

Discount to find present value of

costs and benefits

Suppose your friend owed you $500.

Would you rather have this back to you right away

in one payment, or spread out over a year in four

installment payments? Would it make a difference

in either way?

1 Baht 2010 1 Baht in 2015 1 Baht 2050

Discounting is simply a technique that allows us to compare costs and

benefits that happens at different point in time into a common unit of

measurement.

100 110 121

Year 0 Year 1 Year 2

Assume 10% return on investment:

Compounding

Discounting

Calculate

Present Value

Principle of discounting

Bank

Typically, the flows of costs and benefits of a project look

like this:

Costs

Benefits

C1 C2 C3 C4 C5 C6 C7 C8

0 0 0 B4 B5 B6 B7 B8

Investment costs Operational costs

Costs

Benefits

C1 C2 C3 C4 C5 C6 C7 C8

0 0 0 B3 B4 B5 B6 B7

PV of

Costs

PV of

Benefits

Use this formula to convert all future values to

present values:

PV = FVt/(1 + r)t

where; PV is present value, FV is future value, r

is the discount rate and t is time.

Discounting:

How do we do it?

Let’s use that formula.

What is the value of a $100 tomorrow (one period in the

future)?

Assume discount rate, r, is set to 0.05 THINK!!

Discounting:

How do we do it?

Then,

PV = FVt/(1 + r)t

PV = 100/(1 + 0.05)1

PV = $95.2381

Regardless of how it is derived, the important

thing is how high it is set.

High discount rate = we don’t value the future

as much as the present

Low discount rate = we value the future almost

as much as the present

Discounting: The Debate!

Empirical studies suggest that it should be between 3% and 8%.

More importantly: ALL public sector projects should use

the same discount rate.

In the United States:

Office of Management and Budget uses: 7%;

U.S. Forest Service uses 4%;

NOAA uses 3%;

Department of Interior uses 3%;

EPA uses 3%.

For NT2, World Bank used 10% discount rate.

Discounting: The Debate!

In Thailand: NESDB - discount rate is between 9%-12%

Step 8

Sum:

Add up benefits and costs

Add up costs and add up benefits; if net

benefits are positive do the project!

Decisions are determined by indicators:

- Net Present Value: NPV

- Benefit – Cost Ratio

- Economic Internal Rate of Return: EIRR

Net Present Value: NPV

=

0 0 )1()1(t tt

t

t

t

r

C

r

B

0 )1(

)(

tt

tt

r

CB=

Net Present Value = PV of Benefits – PV of Costs

Where:

B – benefits

C – costs

r – discount ratet – the time of the cash flow

Net Present Value: NPV

Benefit-Cost Ratio: B/C ratio

nn

o

n

no

r

C

r

C

r

CC

r

B

r

B

r

BB

C

B

1...

11

1...

11

2

21

2

21

Where:

B – benefits

C – costs

r – discount rate

Worth investment when B/C > 1

Economic Internal Rate of

Return: EIRR

n

ot

n

ott

t

t

t

r

B

r

C

11

or

n

ott

tt

i

CBNPV 0

1

Where

i - IRR

Worth investment when IRR > r

Step 9

Sensitivity analysis

Risks and Uncertainties

Risk

situations where we do not know the

outcome of a given situation, but can

accurately measure the odds.

Uncertainty

situations where we cannot know all

the information we need in order to set

accurate odds in the first place.

Sensitivity analysis

The process of establishing the extent to which the

outcome of the CBA is sensitive to the assumed

values of the inputs used in the analysis.

+/- in benefit stream

+/- in cost stream

+/- in discount rate

+/- the construction period

Try out worst-

case, best-case

scenarios

Step 10

Make a

recommendation

1

• Present results

• Whether the project is good or bad

2

• Discuss the fact that not all impacts have been subjected to economic assessment

• Distributional issues. Who gains vs. Who lose?

3

• Discuss important sources of uncertainty

Case study

Senegal Irrigation Project

Nianga Irrigation Pilot Project (NIPP).

Life-span of about 30 years.

One of the analyses of this project provided a

very clear schedule of costs and benefits.

Measured in thousands of 1975 CFA Francs

(Senegalese currency)

Senegal Irrigation Project

Period of Time Benefit Schedule Cost Schedule Net Benefit Schedule

Note: we’re only considering agricultural output as a benefit and no others. However a whole slew of other benefits (unmeasured in this project) do exist.:(1) agricultural production; (2) production of rice seed; (3) increased knowledge of the agronomy of irrigated agriculture in the Fleuve Region; (4) improved technical skills of both the farmers who participate in the Pilot Project and those who receive training from the B.I.T. Center; and (5) shelter provided by the 17 houses at Cite SAED

We need to determine if the total benefits exceed

the total costs

If benefits > costs then the project is worth doing

As discussed, we will discount all future costs

and benefits to their present value

Should we go ahead with

this project?

Exercise

Discount rate @ 5%

Calculate PV, PC and BC ratio

Year Period

Total Agricultural

Benefits Total Cost

Benefits without Project

Net Benefits

Discount Rate PV(TB) 5% PV(TC) 5%

BC Ratio

1973 0 0.0 31,320.7 7,248.0 -38,568.7 0.05 0.0 31320.7 .

1974 1 0.0 354,174.0 7,248.0 -361,422.0 0.05 0.0 337308.571 .

1975 2 43,781.3 512,089.9 7,248.0 -475,556.6 0.05 39710.9 464480.635 .

1976 3 157,552.7 124,573.8 7,248.0 25,730.9 0.05 136099.9 107611.532 .

1977 4 164,809.6 144,853.9 7,248.0 12,707.7 0.05 135589.3 119171.662 .

… … … …. … …. … … … …

1998 25 215,364.2 113,642.0 7,248.0 94,474.2 0.05 63597.6 33558.7976 .

1999 26 215,364.2 113,642.0 7,248.0 94,474.2 0.05 60569.2 31960.7596 .

2000 27 215,364.2 113,642.0 7,248.0 94,474.2 0.05 57684.9 30438.8187 .

2001 28 215,364.2 113,642.0 7,248.0 94,474.2 0.05 54938.0 28989.3511 .

2002 29 215,364.2 113,642.0 7,248.0 94,474.2 0.05 52321.9 27608.9058 .

Sum: 2,746,329.56 2,490,685.93 1.10

Graph over Time: No Discounting and Discounting

0.0

100,000.0

200,000.0

300,000.0

400,000.0

500,000.0

600,000.0

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

Total Agricultural Benefits

Total Cost

0.00

100,000.00

200,000.00

300,000.00

400,000.00

500,000.00

600,000.00

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

PV(TB) 5%

PV(TC) 5%

B/C = 1.10

The Kwae Noi Dam

Project background

80% of population are low income

farmers

lack of water supply in dry season;

flood in wet season

Hydroelectric power plant No hydroelectric power plant

System I

-Rice

-Rice

System II

-Rice

-Rice

-Cash crop-Vegetables

-Fruit trees

System III

-Rice-Cash crop-Vegetables

-Fruit trees

System I

-Rice

-Rice

System II

-Rice

-Rice

-Cash crop-Vegetables

-Fruit trees

System III

-Rice

-Cash crop-Vegetables

-Fruit trees

Proposed alternatives for agricultural development

Costs of the project

Benefits of the project

Results of the Feasibility Study

Sensitivity Analysis

The Three Gorges Dam

The Three Gorges Dam

Composition

1.A dam

2.Two powerhouses

3.Navigation facilities

• 15 years of construction

• US$ 25 billion

The Three Gorges Dam

Objectives

1.Flood protection: 10 million downstream

residents

2.Over 20,000 MW of hydropower generation

3.Improved navigation

• VDO clip

Pretending as if you were a developer of the

Three Gorges Dam, what would be the

negative impacts (costs) and positive impacts

(benefits) of the project in terms of

Biophysical

Socioeconomic

Geopolitical

Traditional CBA

Goals:

1) Calculate present value of costs and benefits

2) Examine uncertainty.

Method:

Quantify each effect (e.g. kwhrs of electricity).

Value each effect (e.g. determine its price)

Sum discounted benefits minus costs

Direct Costs

Construction costs of the

power station and

transmission facilities

Operation and maintenance

cost

Lost land from inundation

(reservoir)

Indirect Costs

Resettlement costs

Lost archaeological sites

Decline in biodiversity

Pollution during

construction

Costs

Benefits

Power generation

Flood control

Navigation improvement

Economic growth

(avoided economic

losses from power

shortages)

Avoided damages from

air pollution (from coal)

Direct benefits

Indirect benefits

Expected Results

1,217 770

Interdisciplinary Dam Assessment Model: IDAM

BiophysicalLabel Impact Description Metric

BP1 Water retention time Time water is stored in reservoir Time

BP2 Natural value Potential gain or loss associated with dam

activity

UNESCO natural

selection criteria

BP3 Downstream

tributaries

Number of tributaries for supplying sediment Number

BP4 Biodiversity Endangered plants/ animals % of known

species that are

threatened

BP5 Distance of river left

dry downstream of

dam

Where flow is diverted for irrigation Length

BP6 CO2 equivalent to

coal

Benefit of producing hydropower as opposed to

coal

Pounds / MW

BP7 Flood protection Magnitude of flooding event captured by dam in

return year interval

RYI year

BP8 Site stability Presence of geologic hazard None to very

large

BP9 Reservoir surface Surface area of reservoir at full storage Area

Label Impact Description Metric

SE1 Social cohesion Change in social networks and perceived social

cohesion

Buckner scale

SE2 Cultural change Sites of cultural significance Number

SE3 Non-agricultural

economic activity

Aggregate change in total income Dollars

SE4 Health Frequency and severity of contamination Days / year

SE5 Agricultural

economic activity

Aggregate change in total income Dollars

SE6 Displacement Relocation costs Dollars

SE7 Hydropower Value of hydropower consumed locally/ sold Dollars

SE8 Housing values Hedonic value of recreation and landscape Dollars

SE9 Transportation Value of change in economic activity Dollars

Socioeconomic

GeopoliticalLabel Impact Description Metric

GP1 Downstream riparian

population

Downstream people affected by dam Number

GP2 Downstream

irrigation

Downstream irrigated area affected Area

GP3 Political boundaries No. of national/ sub-national political boundaries

crossed by waterway

Number

GP4 Existing dams Regulatory/ storage capacity of existing dam on

waterway

Capacity

GP5 Agreements/

institutions

No. of inter governmental institutions devoted to

management of shared waterway

Number

GP6 Political participation Plurality of decision making processes in country

where dam will be sited

Democracy

index

GP7 Historical stability Degree of interstate and intra state stability vs.

tension amongst riparian countries

Internal BAR

scale

GP8 Domestic

governance

Durability of state government International

BAR scale

GP9 Socio-economic

impacts for non-

constituents

Estimate of the magnitude of impacts of non-

constituents

Low - high

http://www.eepsea.net

Guidelines for Conducting Extended Cost-benefit Analysis of Dam Projects in ThailandBy Piyaluk Chutubtim

Economic analysis does not and cannot provide all

answers

The role of the economist is to provide information

to decision makers

Results from the economic analysis are not the

only criteria that should be used