Border and shadow pricing

During construction each project incorporates a lot of inputs (resources) such as equipment, materials, land and manpower. During the lifetime of the project it also consumes inputs, and produces output (product). Among the most important oper- ational inputs in power projects are fuel, manpower and similar resources. In the financial evaluation these inputs are valued at their market prices. Market prices are almost never ideal and are often distorted to varying degrees in different countries. The industry and investors are mainly interested in market prices of inputs and outputs because that is what they have to deal with and it is these prices that determine financial profitability. Economic evaluation goes beyond this by investigating the true impact of the project on the national welfare. To achieve this, prices of resources must be set at their true cost to the economy [9].

Inputs and outputs can be classified into two categories: traded and non-traded. A project input or output is deemed to be traded if its production or consumption will affect a country’s level of imports or exports at the margin. A project input or

output is considered to be non-traded because of its bulkiness, cost consideration and immobility or other restrictive trade practices. Machinery and equipment, as well as fuel and skilled labour and marketable products, are considered tradable. Non- traded goods and services include items like land, water, buildings, unskilled labour, electricity (in most cases) and many other services and bulky material. Traded and non-traded goods and services are part of project inputs and outputs. For economic evaluation they have to be priced at their true cost to the economy.

7.5.1

Pricing traded inputs and outputs

Because they can be traded, i.e. imported as well as exported, tradable inputs and outputs create a change in the country’s net import or net export position at the mar- gin. They must be valued, in economic evaluation, at border prices. Border prices are world prices, free on board (FOB) for exports and cost, insurance and freight (CIF) landed cost for imports, adjusted by allowing for domestic transfer costs. Trans- fer costs are costs that are incurred in moving inputs and outputs between project site, border and target markets.

Take coal as an example. The border price of imported coal, which will be incorpo- rated in the economic evaluation, will be the CIF price at the nearest port plus handling and transport charges to the generating plant. If this coal is produced locally, its eco- nomic price will be its FOB price at the port of export minus the cost of transport from the coalmine to the port plus the cost of transport to the generating plant. For bulky materials, like coal, such transport prices are significant and greatly favour local production.

Consider an example in which coal can be imported by country ‘y’ at $80 ton−1 with transport cost between country ‘x’ and country ‘y’ at $20 ton−1. If country ‘x’ would export its production to country ‘y’ then it has to price it at $60 ton−1 ($80− $20 ton−1). If the cost of handling this coal and transporting it to the export port of country ‘x’ is $15 ton−1, then coal at the mine-mouth has to be $45 ton−1. If this coal will be used locally instead and with transport plus handling cost of $5 ton−1from the local mine to the local power station then the economic cost of coal, will be $45+ $5, i.e. $50 ton−1, irrespective of the actual cost of extraction, which can be much less.

If the cost of production of coal in country ‘x’ increases and it considers importing outside coal from a source with a sea transport cost of $15 ton−1, then its cost CIF of imported coal will be $50+ $15 = $65 ton−1. If transport of this coal to the power station will involve another $8 ton−1then the total cost of imported coal to the power station will be $73 ton−1.

Country ‘x’ is advised to continue production of coal as long as its production cost is equal to $68 ($73− $5 ton−1local transport cost from mine to power station). If country ‘x’ decides to continue producing coal from its mines, even if its production cost reaches $90 ton−1, while selling it at $70 ton−1to the power station, then its coal subsidies will amount to $20 ton−1. Such subsidies are excluded in the economic evaluation. The market price for coal will be $70 ton−1in the financial evaluation of the investors, and $73 ton−1(i.e. the border price) in the case of economic evaluation.

A decision to utilise a local resource (like coal) is not dependent only on produc- tion costs and border prices but is also influenced by many other political and social considerations, like utilising local resources, creating local employment, supply secu- rity and shortage of foreign exchange. In making such decisions, however, the border price of coal has to be calculated and taken into consideration in evaluating plans and decisions.

7.5.2

Pricing non-traded inputs and services

Non-traded goods and services are priced at their shadow price. A lot of research was done in understanding and evaluating shadow pricing [3–6]. With the enhancement of free trade, freely convertible currencies and open markets, shadow pricing is still required but not to the extent it was in the past.

In evaluating non-traded goods and services it is essential to differentiate between non-traded tradables and non-tradables. Non-traded tradables are goods and services that can be traded on the international market but are not because of their cost being higher than international prices (e.g. local low quality coal), or because of trade restric- tions and policies (quotas, restrictive import taxes at potential import markets, etc.).

A good example of a non-traded tradable is coal. If the international price of coal is $50 and its transport to the power station involves an additional $23, a local coalmine with a high production cost of $68 (which is above international prices hence rendering its product a non-traded tradable) will continue production protected by the high transport prices. In such cases the economic price of a non-traded tradable commodity is the opportunity cost of the product, that is the price it can command in the absence of the project.

Most power projects involve non-tradable inputs, mainly materials for civil works and labour. Such inputs can be decomposed into its components. Large civil works like a power station building contain tradable and non-tradable components. Tradable inputs (cement, steel, etc.) can be priced in accordance with their border prices. Non- tradable inputs (gravel, sand, stones, labour, etc.) have to be shadow priced through utilising conversion factors [9]. The most widely used factor is the standard conversion factor (SCF). This factor is the average ratio of border and domestic market prices and is equal to

M+ X

(M+ Tm)+ (X − Tx)

where M = CIF value of imports, X = FOB price for exports, Tm = all taxes on imports, Tx = all taxes on exports. Through applying this conversion factor by multiplying it by the non-tradable inputs it is possible to reduce the impact of local distortions. In a way the SCF is the ratio between an official and a shadow exchange rate. In developing countries it is usually less than unity, signifying that the local currency is overvalued.

Consider a country with imports valued at 100 million currency units and exports of 50 million units, import taxes of 20 million units and export taxes of zero. The SCF

is equal to 0.88 (which is (100+ 50) million divided by [(100 + 20) + (50 − 0)] million). It is also usual to have a SCF equal to 1.0 for skilled labour and 0.5 for unskilled labour.

An example is a power station building, which is priced in local currency as shown in Table 7.1. The conversion factors for steel and cement were calculated using border prices as shown. The economic cost of the power station building will be as detailed in local currency. An estimation of economic costs and benefits is given in Table 7.2.

Table 7.1 Conversion of financial cost of a power station civil work component into economic cost (in local currency units)

Component Financial cost Conversion factor Economic cost Traded items

Cement 10 000 0.90 9000 Steel 30 000 0.80 24 000 Non-traded items

Other building materials 10 000 0.88 8800 Overhead 20 000 0.88 17 600 Unskilled labour 25 000 0.50 12 500 Skilled labour 5000 1.00 5000 Total 100 000 0.77 76 900

Table 7.2 Estimation of economic costs and benefits [9]

Project inputs

A Net imports of tradable items (CIF plus converted port-to-project costs) B Diverted net exports of tradable items (FOB minus converted source-to-port plus

converted source-to-project costs) C Non-traded items

1 Land (converted opportunity cost) 2 Labour

(a) Skilled (market wage rate)

(b) Unskilled (converted shadow wage rate)

3 Goods (converted domestic market price plus converted source-to-project costs) Project outputs

A Net exports (FOB minus converted project-to-port costs)

B Import substitutes (CIF plus converted port-to-market costs and minus converted project-to-market costs)

7.6

References

1 FEDLER, F.: ‘Integrating financial theory and methods in electricity resource planning’, Energy Policy, February 1996, 24, (2)

2 KHATIB, H.: ‘Financial and economic evaluation of projects’, Power Eng. J., February 1996, 10, (1)

3 SQUIRE, L., and VAN DER TAK, H.: ‘Economic analysis of projects’ (The Johns Hopkins University Press, 1989)

4 RAY, A.: ‘Cost-benefit analysis’ (The Johns Hopkins University Press, 1990) 5 LAL, D.: ‘Methods of project analysis’ (International Bank for Reconstruction

and Development, Washington DC, 1976)

6 LITTLE, I. M. D., and MIRRLFES, J. A.: ‘Project appraisal and planning for developing countries’ (Heinemann Educational Books, 1974)

7 ‘Appraisal of projects in developing countries’ ODA (Overseas Development Administration), (HMSO, 1988, 3rd edn.)

8 GITTNER, J. P.: ‘Economic analysis of agricultural projects’ (The Johns Hopkins University Press, 1982, 2nd edn.)

9 CHRISTIAN, D. J., and PRASAD, R.: ‘Guidelines for calculating financial and economic rates of return for DFC projects’ (International Bank for Reconstruction and Development, Washington DC, 1984)

Environmental considerations and