Practical Applications

Two of the principal authors of the original methodology reflected on the neglect of this approach in the World Bank, the institution that had been most active in promoting their work initially (see Little and Mirrlees 1994).29 _{Their position was purist in that while the full procedures of}

their method were never applied, a simplified form of economic analysis has been used by most donors and even by some developing country governments. The current practice— for example, as recommended for ADB in ADB (1997), and for the World Bank in Jenkins (1997) and Belli et al. (2001)—is to conduct calculations of economic costs and benefits while at the same time examining a project in the context of both sector and macro policy in the economy concerned. Hence, while inevitably, the estimates of benefits and costs at the project level are partial, in the sense that all linkage and iterative effects cannot be quantified, an underlying justification or rationale for a project must be established in

29 _{World Bank (2010) also finds a declining percentage of World Bank projects that are justified by}

CBA. The study recommends revisiting World Bank policy for CBA, recognizing the difficulties in quantifying benefits while ensuring analytical rigor. It also calls for reforms in appraisal procedures to ensure the effective use of CBA in decision making.

addition to the standard discounted cash flow indicators of NPV and IRR. However, the latter provides a key check on the reasonableness of the case for a project, since they give the only comprehensive quantitative estimate of acceptability.

Practice in regional development banks follows that of the World Bank in distinguishing between projects with quantifiable benefits and those without. For the former, a cut-off rate of discount (normally 12%) is used as a rationing device so that an acceptable project must have a positive economic NPV at this rate or an economic IRR of above 12%. For the latter category of projects with non-quantifiable benefits in monetary terms, cost-effectiveness comparisons are applied to ensure non- monetary benefits are maximized per unit of cost. There is also evidence from evaluation studies that the initial quality of project economic analysis work prior to implementation is correlated with the likelihood of subsequent project success (at least for the World Bank), since a careful economic analysis helps to identify the key obstacles a project is likely to face (Deverajan et al. 1996, Deininger et al. 1998).

In the period from 1960 to the early 1990s, a number of national governments in developing countries possessed planning agencies which applied national shadow price estimates consistently in the appraisal of public sector projects. The list of such countries is diverse, and includes India, People’s Republic of China (from the late 1980s), Chile, Ethiopia, and Jamaica. Many more conducted a simpler form of appraisal that was distinct from financial analysis in omitting transfers and approximating non-marketed or externality effects. As noted above, the appraisal of public sector projects no longer requires major shadow price adjustments in most countries, but developing country governments remain important providers (or partners in public-private initiatives) of physical and social infrastructure whose economic benefits will typically not be captured in market transactions and will therefore not show up in financial appraisals. In addition to its role in the assessment of individual projects, economic analysis is an important aid to the design of sector strategies, for example in relation to the choice of energy sources and technology. The decision whether or not to privatize or to embark on public-private partnerships also requires a systematic comparison of costs and benefits over time and thus also lends itself to this form of analysis.30

30 _{Jones et al. (1990) provide an example of a cost−benefit approach to privatization in developing}

Project economic analysis likewise retains its relevance in the context of higher income economies. It is used routinely when government economists assess the use of public funds in a variety of sectors; for example in road, rail, and air transport, and in the social sectors of health and education. Even where public funds may not be used directly, CBA may nonetheless be used to assess the attractiveness or otherwise of various options, for example in relation to energy strategy (the thermal versus nuclear choice), environmental protection, and the costs of climate change.

A number of Organisation for Economic Co-operation and Development (OECD) governments regularly use CBA to assess their public sector projects. For example, the UK government regularly produces guidance notes on the application of economic analysis in the context of the UK public sector and argues that where there are quantifiable benefits and costs from a project these must be incorporated in a formal cost−benefit comparison (see HM Treasury 2008). This approach is applied as standard practice in the UK road sector where project economic analysis is combined with wider transport modeling (see Chapter 7). The highly influential review on climate change for the UK Treasury (Stern 2007) utilizes the CBA framework to compare the discounted costs of acting now to address climate change with the discounted benefits, defined as long-run avoided costs. Much of the academic debate on the merits of this study focused on the basic question from project economic analysis of whether the correct discount rate was used (Beckerman and Hepburn 2007, Cline 2007, Dasgupta 2008).

Similarly, the European Commission has judged that it is important to use economic analysis in the appraisal of projects financed out of its Structural and Cohesion Funds which are designed to assist the less developed regions of the European Union. During the 1990s, it produced a series of documents to guide the application of project analysis (for example, European Commission 1997). More recently, it has produced a comprehensive guide that incorporates all of the key features of the literature outlined above (European Commission 2008).31 _{This application}

in a European context highlights the general applicability of the cost− benefit approach. ADB and other regional development banks continue

31 _{The EU Cohesion Policy requires that all major investment projects, normally defined as those}

costing more than Euro 50 million (but more than Euro 25 million for environmental projects and Euro 10 million for Pre-Accession Assistance projects for new member states) be subject to a formal cost−benefit analysis. Amongst other things the 2008 Guide suggests discount rates of 3.5% or 5.5% varying with country prospects, and the use of economic prices and of risk analysis in project calculations.

to stress that a rigorous application of project economic analysis is a critical component of the planning and approval process. However, as noted above, project economic analysis is defined in broader terms than was once the conventional interpretation of CBA.

A project is viewed in the context of the economy and sector in which it is located, and alternatives are assessed not just technically, but also in terms of ownership and institutional structure. Results are presented not just in terms of single economic NPV and IRR indicators, but also in terms of their probability of occurrence, as well as first-round estimates of gainers and losers. Ex ante economic analysis is followed up at different stages of project life both to monitor progress, anticipate or remove bottlenecks, and to learn lessons for similar future projects. Box 2.1 summarizes the different dimensions of project economic analysis as interpreted by ADB under 10 headings.

Box 2.1 Ten Key Areas of Economic Analysis for ADB Projects

Macroeconomic Assessment: What macro economic factors affect target sectors and vice versa?

Assessment of macro and sector polices as they impinge on a project; analysis of economic outlook and key projections; estimation of country-wide national economic parameters like standard conversion or shadow exchange rate factor.

Sector Assessment: What are the binding constraints to the functioning of markets and efficient and equitable provision of public services?

Assessment of sector performance, institutional and ownership structure and performance, and policy environment; identification of binding constraints on sector performance, market and non-market failures, and the most appropriate form of development assistance.

Demand Assessment: How much of the output is wanted? How much are users willing to pay for the output?

Estimation of demand in a sector; key factors influencing demand; potential willingness to pay for project output; impact of price changes.

Economic Rationale: What market failures justify the public sector interventions? What non-market or institutional failures justify policy and institutional reforms? Is there a conducive business environment for private sector to participate?

Description of market or institutional failure to be addressed; rationale for public sector involvement and role of private sector; strategic relevance of proposed project and justification for the form of ADB involvement; relevance of the project to national development plans.

Project Alternatives Analysis: What is the best way of addressing the market or institutional/policy failure problems?

Identification of with- and without-project scenarios; assessment of project alternatives in terms of location, scale, technology and timing; least-cost analysis as basis for project selection.

Cost−benefit Analysis: Will the project benefits exceed the project costs?

Measurement of main benefits and costs in with- and without-cases; establishing whether some effects cannot be quantified and where necessary using cost- effectiveness analysis; choosing numeraire and price level for shadow pricing; estimating economic NPV and IRR for each independent sub-component and for project as a whole; describing effects that could not be quantified in money terms; conclusions on project acceptability.

Financial and Institutional Sustainability: Are there enough resources to maintain the flow of project benefits?

Estimation of financial IRR for revenue generating projects; assessment of whether the financial returns to investors are sufficient to ensure their involvement; indication of expected user charges and any implied subsidies; estimation of fiscal impact of the project and its implications for government involvement; assessment of the institutional capacity of project-related agencies to meet project input and service delivery.

Distribution Analysis: Who benefits from the project, and by how much?

Identification of key project stakeholders; assessment of benefit incidence; estimation where possible of allocation of net project income between different groups; where appropriate identification of effects on key target groups, like the poor or ethnic minorities.

Risk and Sensitivity Analysis: What are the chances that benefits and costs will be realized as anticipated?

Identification of key project parameters and their likely variability; calculation of the switching value of key parameters and an assessment of the likelihood of its occurrence; quantitative risk analysis based on probability distributions for key variables; assessment of institutional risks; identification of measures to monitor and reduce project risk.

Monitoring & Evaluation: Do the assumptions maintain their validity throughout the project life?

Listing key parameters for monitoring; identification of the requirements for future data collection on all key parameters.

Source: Adapted from ADB (2004).

The 10 areas covered in project economic analysis provide a comprehensive framework for analyzing the economic viability of a project in ADB practice. In addition to economic analysis, an environmental impact assessment, a social safeguard assessment, including resettlement and gender issues and poverty, are undertaken. These supplementary assessments provide additional information for economic analysis and generally, the cost of implementing an environmental management plan and resettlement plan, including compensation payments, are included in the project costs. Many aspects of the alternative analysis described in Table 2.1 are covered in this framework, except for explicit use of multi-criteria analysis.

One noteworthy point is the frequently overlooked link between project economic analysis and the design and monitoring framework. The tenth aspect of project economic analysis highlights this link but indicators for monitoring and evaluation are often selected without paying attention to the original project economic analysis. There is a clear synergy that can be harnessed to strengthen the monitoring and evaluation process. For example, many irrigation projects assume a certain level of crop yield and a project’s success depends critically on achieving these yields. Similarly, forecast traffic flows and vehicle operating cost reductions determine the economic viability of a road improvement project. Selecting a set of indicators that determine a project’s economic viability, in addition to the usual indicators of construction timing and quality would enhance the effectiveness of the monitoring and evaluation process.

2.6 Conclusions

Project economic analysis no longer fuels major academic debate since most theoretical issues have been resolved. The major exception relates to the treatment of risk and in particular, environmental risk and sustainability and how these are best addressed, about which there is still dispute. Environmental externalities have been discussed extensively in the literature over many years, but the recent focus on climate change has heightened awareness that in principle all projects have some environmental consequences, however small. Current thinking emphasizes the need to build into appraisal an awareness of

environmental impacts and where possible, to quantify these as either costs or benefits.

The current policy environment in developing countries differs significantly from that of the 1960–1990 periods after macroeconomic reforms and privatizations in most countries. This has meant that the key issues appraisals need to address, have shifted from macroeconomic distortions to non-market and hard-to-value activities and distributional and poverty concerns. However, the methodology is sufficiently flexible to cope with the demands of the new agenda. There have been major advances in eliciting the stated preferences of individuals and households to approximate WTP for various project outputs. In addition, there has been a revival of interest in tracing through the distributional consequences of projects, without going as far as the controversial step of differentially weighting income flows to different groups.

In practical project applications in sectors such as transport, power, and water, the concepts of demand margin (for incremental consumption of a good) and supply margin (where costs of other producers are saved) are used widely to obtain estimates of tangible economic benefits. Within different sectors, different practical procedures have been developed, although the rigor and accuracy of these approaches vary and a selective application of rigorous contingent valuation studies and other non- market valuation methods offers a promising way forward for valuation of hard-to-value project outputs.

The key point is that for the type of projects supported by governments or donors today, financial appraisal alone, while important as a guide to long-run viability, rarely gives a full picture of a project’s economic worth. For these projects, a related but separate economic analysis remains both relevant and important.

3. Theory and Practice in the