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Last Update 26/02/2007 Lecture Notes ECON 622 ECONOMIC COST-BENEFIT ANALYSIS Lecture One

Last Update 26/02/2007 Lecture Notes ECON 622 ECONOMIC COST-BENEFIT ANALYSIS Lecture One. The Role of Investment Appraisal. To stop bad projects – bad policies To prevent good projects from being destroyed To determine if components of projects are consistent

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Last Update 26/02/2007 Lecture Notes ECON 622 ECONOMIC COST-BENEFIT ANALYSIS Lecture One

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  1. Last Update 26/02/2007 Lecture Notes ECON 622 ECONOMIC COST-BENEFIT ANALYSIS Lecture One

  2. The Role of Investment Appraisal • To stop bad projects – bad policies • To prevent good projects from being destroyed • To determine if components of projects are consistent • To assess the sources and magnitudes of risks • To determine how to reduce risks and efficiently share risks

  3. Questions addressed by an Integrated Project Analysis • Is the project financially or fiscally sustainable? • Does the project contribute to the economic growth of the country? i.e. positive expected economic NPV • What are the sources and magnitudes of risk? • Who are beneficiaries of project and by how much? • Who are the interest groups (stakeholders) who could distort the investment decision or affect the project’s performance? • What are the risks associated with the benefits accruing to the stakeholders? Sources of political risks? • Are poverty alleviation goals being addressed? • What are the fiscal impacts? • What is the personality of the project?

  4. Incrementality of Projects • One of the important concepts when defining a project is to measure the impact of the project’s cash flows and net benefits and costs on an incremental basis. • We should carefully identify the benefits and costs that are only associated with the project, and not include any other benefits that would exist “WITHOUT” the project being undertaken. • It is normal for the benefits and costs to change over time for the “WITHOUT” project case. • The “WITHOUT” project scenario must be properly defined before using it as the base case from which to measure incremental benefits and costs produced by the “WITH” project case. • It is an optimized “WITHOUT” project situation that should be compared with the “WITH” project situation to calculate the incremental benefits and costs. • There is another perspective “before the project” versus “after the project” scenarios. “Before the project” is NOT the appropriate base case from which to measure incremental benefits and costs.

  5. Stages in Investment Appraisal and Approval Why should a project evaluation be done in stages? A. Idea and Project Definition B. Pre-Feasibility Study C. Feasibility and Financing D. Detailed Design • Project Implementation • Ex-Post Evaluation

  6. Key Initial Questions a. Where is the demand? b. Is this project consistent with the organization’s expertise, current plans and strategy for the future? Can the project be implemented and operated in a reasonably efficient manner?

  7. Project Definition • Project definition is defined broadly to include the scope and specification of the objectives of the project, its output, its different stakeholders, the expected types of economic and social benefits, and the data requirements. • Most of the project’s data requirements are identified in the pre-feasibility and feasibility stages of the project where the project’s variables and parameters are analyzed in detail. • The data are generally arranged in what we refer to as “building blocks” because they constitute the foundation for the different types of analyses.

  8. Modules of Pre-Feasibility and Feasibility Studies • Why break study into modules? Building Blocks A. Demand (including environmental factors) Module B. Technical (including environmental factors) Module C. Environmental Assessment Module D. Human Resources and Administrative Support Module E. Institutional Module Analysis Modules F. Financial/Budget Module G. Economic Module H. Stakeholder and Basic Needs Analysis

  9. Analysis Module F: Financial Module What is done: • Integration of financial and technical variables from demand module, technical module, and management module – this is not a mechanical exercise • Construct cash flow (resource flow) profile of project • Identify key variables for doing economic and social analysis Key questions: a. What is relative certainty of financial variables? b. What are sources and costs of financing? c. What are minimum cash flow (benefit) requirements for each of the stakeholders? d. What can be adjusted to satisfy each of the stakeholders?

  10. Analysis Module G: Economic Module What is done: • Examines the project using the whole country as the accounting entity • Evaluation of externalities including environmental Key questions: a. What are differences between financial and economic values for a variable? b. What causes these differences? c. With what degrees of certainty do we know the values of these differences? d. What is the expected value of economic net benefits? e. What is the probability of positive economic feasibility?

  11. Analysis Module H: Stakeholders and Basic Needs Analysis What is done: • Identification and quantification of extra-economic impacts of project • Distributive Appraisal • Income, Cost, and Fiscal Impacts on various stakeholders • Poverty Alleviation and Political Necessities • Basic Needs: Evaluate the impact of project on achieving basic needs objectives • Basic needs will vary from country to country Key Questions: a. In what ways does project generate beneficial and cost impacts on stakeholders? b. What stakeholders could the project impact? c. Who benefits and who pay the costs? d. What are the basic needs of the society that are relevant in the country? e. What impact will the project have on basic needs? f. What alternative ways are there to generate desirable social impacts? g. Is project relatively cost effective in generation of desirable social impacts?

  12. ECONOMIC VALUE ECONOMIC VALUE = FINANCIAL VALUE = + TAX IMPACT + NET BENEFITS TO CONSUMERS NET LABOUR BENEFITS FINANCIAL VALUE + TAX IMPACT NET BENEFITS TO CONSUMERS NET LABOUR BENEFITS

  13. General Relationship NPVECOeco. dr= NPVFINeco. dr+ PVEXTeco. dr

  14. Case Studies • Issues facing decision makers in Olifants-Sand Water Transfer Scheme (OSWTS)? • Structure of an Integrated Analysis of Manila South Water Distribution Project.

  15. Olifants-Sand Water Transfer Scheme (OSWTS) Limpopo South Africa • Lack of water supply impedes economic and social development- shortages as early as 2004 • About one million people in region affected by OSWTS • 79% of population have < 25 l/c/d consumption of waters

  16. SUPPLY OF WATER Status Quo • Yield of the existing Flag Boshielo dam is fully rationed • Underground water resources are not reliable and cannot support development of the mining sector • The only available source of water supply is development of the Olifants river resources or similar river resources

  17. Choice of Development Strategy, Scale and Timing using Cost-Effectiveness Analysis Options: • Selection of Development Strategy for Olifants River water resources: • raising Flag Boshielo Dam (temporary measure), or • construction of Rooipoort Dam, or • raising Flag Boshielo Dam and construction of Rooipoort Dam • Rooipoort Dam – site location: • "downstream" versus “upstream" site • Rooipoort Dam – scale (size of dam): • “full supply level” of dam (there are 3 proposed levels at each site location) • Flag Boshielo and Rooipoort – “optimal” timing • should dams be postponed and by how long?

  18. Development Strategy: Rooipoort is built (Flag Boshielo is not raised) • Some shortages in 2004-06, before start of Rooipoort operation • PV of water shortages vary from 15.6 to 56.4 million m3

  19. Water Demand and Supply: Flag Boshielo+5m and Rooipoort, million m3.

  20. Average Economic Unit Cost of Water “Delivered to Bulk Users” with Different Economic Opportunity Cost of Water Shortage, R/m3. Roo ipoort Site: Upstream Downstream FSL725 FSL724 FSL728 FSL731 FSL720 FSL731 Rooipoort (Flag Boshielo is not raised) 3.40 2.43 2.07 3.53 2.39 1.95 1.87 Flag Boshielo+5m and Rooipoort 2.1 2 1.91 2.21 1.94 1.89 • The Economic Cost-Effectiveness recommended a strategy with a cost of water of 1.87 Rand/m3 rather than the political option that would have had a cost of 3.40 Rand/m3. • None of the technical or political groups had identified the Flag Boshielo plus Rooipoort at its largest scale as the most cost-effective option.

  21. MEASURING THE IMPACT ON POVERTY Consumer Surplus of an Individual Water Consumer. • Estimation of consumer surplus is possible • Survey of willingness to pay carried out • Rural users are the poorest of the poor in South Africa.

  22. Average Average WTP Tariff 3 3 (R/m ) (R/m ) User Domestic Urban Potable Water 40.0 0.34 Washing Water 7.0 0.34 Commercial 8.0 6.85 Industrial 8.0 7.63 Municipal 8.0 7.88 AMPLATS Smelter 5.0 4.90 Olifants River Rural Potable Water 30.0 0.34 Washing Water 5.0 0.34 Lebalelo Rural Potable Water 30.0 0.34 Washing Water 5.0 0.34 Groothoek Hospital 8.0 5.72 Lebowakgomo Potable Water 40.0 0.34 Washing Water 7.0 0.34 Private 8.0 5.72 Irrigation 1.5 0.30 5.0 Lebalelo WUA 1.50 Willingness to Pay for Water • Adopted WTP estimates are biased downwards

  23. Flag Boshielo+5m (Rooipoort is not built) Distribution of Consumer Surplus among Different Water Users, R2002 million. Rooipoort Flag Boshielo+5m (Flag Boshielo and Rooipoort is not raised) Lebowakgomo Area 27.5 61.8 74.0 Rural Users 109 .8 291.2 338.7 Mining 98.3 231.4 271.7 Polokwane 8.5 22.6 26.6 Irrigation 28.5 65.5 77.0 Total 275.6 674.5 788.0 • Rural users of Limpopo are poorest of poor in South Africa.

  24. CONCLUSION • Recommended strategy is with Flag Boshielo raised plus Rooipoort built at size (FSL731). • Economic analysis reveals that the true economic costs of water supplied by the OSWTS are lower than the corresponding financial estimates. • Rural users are major net beneficiaries of scheme. • The direct impact on their real income is over 338 million Rand.

  25. Manila South Water Distribution Project Basic Facts: • The Metropolitan Waterworks and Sewerage System (MWSS), the agency that operates water supply and distribution schemes in the Metropolitan Manila area, had identified south Manila as the region with the greatest need for increased access to potable piped water in the Philippines. • In the southern part of Metropolitan Manila, only about 30% of the area’s population had access to piped water supply in 1990. • The goal of the project was to bring sufficient amount of quality improved potable water to 85% of the region’s households, while improving health problems caused by inadequate clean water supply and sanitation services in the region. • The MWSS proposed to construct new clear water reservoirs and pumping stations, and expand its network of transmission mains, secondary distribution pipes and service connections. • The primary investment was to be completed by 1995, but the project had continued making additional investments in service connections through the year 2004.

  26. Manila South Water Distribution Project • The total cost of the project was estimated at 1,369.5 million 1990 Philippine Pesos. • The Asian Development Bank and other financial institutions financed about 63 per cent of the initial investment cost while the MWSS covered the rest of the investment cost. • The project is expected to operate for 30 years. Project outcomes: • Financial analysis based on the proposed structure of the water tariff rate, indicated that project was marginally negative with a net present value of -77.76 million pesos. • The results of the economic analysis indicated positive economic NPV of 2117.87 million pesos. • The break even price for new expansions is about Ps. 5.2/m3.

  27. The Economic Benefits of Water to Paying Customers Drinking Water A P0 37 D P2 20 P1 5 C Q0 QS QT 75% of QT 25% of QT QT-QS= Incremental Project Water consumed by Paying Users At P = 5, Q = QTd = -0.22 Average Economic Price of Drinking Water = .75 (28.5) + .25 (21) = 26.6 Pesos/m3

  28. Demand for Water from Well Demand for Washing Water from Manila Water and Sewerage System B(0,10) C 6 .0 A(12618,5.0) 5.0 B D M Q Q Q T 0 1 ( 2 5236) (12618) (10094) At P0Q0 the d = -1, hence at P > P0 then |d| > 1 Average Economic Price of Washing Water = 7.5 Pesos/m3

  29. PRE-PRIVATIZATION MWSS: THE DECISION TO PRIVATIZE • Only 67% water supply coverage; 8% connected sewerage. • High technical/commercial loss (65% lost) • Average 16 hours per day water availability; 60% non-revenue-water. • 8,000 employees. 9 employ. per 1000 connections (Singapore 1 employee per 1000) • Debt service US$100m p.a.

  30. OBJECTIVES OF PRIVATIZATION • Improve standards of service. • Expand coverage of service. • Increase water supply system efficiency (reduce non-revenue water). • Eliminate fiscal burden on government.

  31. PRINCIPAL ELEMENTS OF CONCESSION STRUCTURE • Twenty-five year concession for water and sewerage given in 1997. • Separation of service area into two zones. • MWSS debt service paid for by concessionaire. • Concessionaire responsible for augmentation of water supply. • Regulatory office responsible for tariff review. • Limited government guarantees. • Bid award based on lowest submitted tariff.

  32. BID AWARD BASED ON LOWEST SUBMITTED TARIFF • Four bidders bid for each concession zone. • Bid was awarded on the basis of the lowest combined tariff for both zones, subject to no one bidder winning both zones. • Manila Water bid lowest tariff for each zone; Maynilad bid second lowest tariff for Zone West. • Manila Water awarded Zone East; Maynilad Water awarded Zone West.

  33. BID AWARD BASED ON LOWEST SUBMITTED TARIFF • No incentive for expansion as tariff is not high enough to cover costs

  34. Current Status of Water Tariff Results: • Manila Water – Profitable • Maynilad Water – Bankrupt

  35. Project Parameters, and Real Investment Table Project Parameters, and Real Investment Table (Tables 1a, 1b, 1c, and 1d) (Tables 1a, 1b, 1c, and 1d) Inflation and Exchange Rate Projections Inflation and Exchange Rate Projections Financial Analysis Financial Analysis (Table 2) (Table 2) Production and Sales Production and Sales (Table 3a, 3b, 3c and 4) (Table 3a, 3b) Loan Schedule Loan Schedule (Table 6) (Table 6) Tax and Economic Tax and Economic Depreciation Depreciation Operating & Maintenance Expenses and Working Capital Working Capital Schedule Schedule (Table 5) No tax depreciation table for No tax depreciation table for Unit Cost of Production (Table 4, Table 5) Manila project Manila project (End of Table 5) as no income tax as no income tax (Interest Expense) (Interest Expense) (Cost of Good Sold) (Cost of Good Sold) (Depreciation Expense) Income Tax Statement Income Tax Statement (Manila water project does not pay corporate income tax ) (Manila water project does not pay corporate income tax ) (Taxes) (Taxes) Total Investment Cash Flow (Nominal) Total Investment Cash Flow (Nominal) (Table 7) (Table 7) Total Investment Cash Flow (Real) Total Investment Cash Flow (Real) (Table 8) (Table 8) (Loan) (Loan) Debt Service Capacity Ratios (Table 9) Debt Service Capacity Ratios (Table 9) (Loan) (Loan) Equity Holder’s Cash Flow (Nominal) Equity Holder’s Cash Flow (Nominal) (Table 10) (Table 10) Equity Holder’s Cash Flow (Real) Equity Holder’s Cash Flow (Real) (Table 11) (Table 11) Figure 1: Project Parameters

  36. Figure 2 : Economic Analysis • Step One:National Economic Parameters: • a. Economic Opportunity Cost of Capital • b. Foreign Exchange Premium (provided by other study for Manila Water Project) + • Step Two: • Economic Conversion Factors for: • a . Economic Value of water (Table 12) • b. Project Inputs, including • Investments • Operating Expenses • Labor • Working Capital • c. Summary of Conversion Factors (Table 13a-13b) (Applied to Real Financial Cash Flow Statement) • Statement of Economic Costs and Benefits • (Table 14)

  37. Figure 3: Distribution Analysis • A. Economic Real Net Resource Flow • (Table 14) - (Minus) B. Financial Real Net Resource Flow (Table 8) (Yields) C. Net Resource Flow of Externalities (Table 15) D. Distribution of Externalities (Present Value) (Table 16) E. Reconciliation of Economic and Financial Analyses: (Table 17)

  38. Figure 4: Risk Analysis • A. Sensitivity Analysis • (Tables 18, 19) B. Risk Variables (Table 20) C. Results (Table 21, Figure 1 and 2)

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