Economic Analysis Concepts

2 Is the project justified ?- Are benefits greater than costs? Which is the best investment if we have a set of mutually exclusive alternatives? If funds are limited, how should different schemes be ranked? When should the road be built or upgraded? Questions & Decisions (1)

3 What standard of construction should be used? What standard and frequency of road maintenance is optimal? Should staged construction be used? Are complementary investments required? Questions & Decisions (2)

4 All appraisals need a framework or model for: a) Forecasting changes b) Evaluating those changes Appraisal Framework

5 Costs and benefits are measured in money terms Road construction and maintenance costs are compared with estimates of the direct primary benefits going to road users and road agency Secondary benefits are usually ignored Economic prices are used in constant terms Components of Economic Analysis (1)

6 Costs and Benefits are forecast over the planning time horizon (usually between 10 and 20 years) Future Benefits are valued less as time progresses using the planning discount rate Costs and Benefits are compared using decision criteria such as NPV, IRR, etc. Components of Economic Analysis (2)

7 The cost to the economy of road rehabilitation and maintenance may differ from the financial cost because of : taxes and duties shortage of foreign exchange under-employment The Government will usually be concerned with ECONOMIC costs. Contractors will usually be concerned with FINANCIAL costs. Economic and Financial Prices

8 In an Economic Appraisal we use ECONOMIC (or SHADOW) prices NOT FINANCIAL prices Adjust financial prices as follows: Exclude all taxes and duties and subsidies Use the planning discount rate not financial market rate If overvalued exchange rate then value imports and exports more highly Use the opportunity cost of labor Standard Conversion Factors are now widely used for road construction costs Use of Economic Prices

9 Changes in transport costs occur because of : Lower road roughness Shorter trip distance Faster speeds Reduced chance of impassability Reduced traffickability problems Change in mode Benefits from Road Investment

10 Management (including design and supervision) Labor Equipment Materials Land, Resettlement, Environment Project Costs

11 Reduced vehicle operating costs (VOC) fuel and lubricants vehicle maintenance depreciation and interest Tire wear Crew time overheads Reduced journey time drivers, passengers and goods Primary Effects (1)

12 Changes in road maintenance costs Changes in accident rates Increased travel Environmental effects Change in value of goods moved Primary Effects (2)

13 Changes in agricultural output Changes in services Changes in industrial output Changes in consumers behavior Changes in land values Changes in income Secondary Effects

14 Captures primary benefits Advantages: Simple, cost based, traffic approach dependent on predicting changes in traffic Disadvantages: May not address critical factors promoting either rural development or social access Consumers’ Surplus Approach

15 C1 C2 T1T2Traffic Cost Demand Curve (Price Elasticity of Demand) Total Benefits = Additional benefits to Generated traffic + Normal and Generated Traffic Benefits Transport cost savings to Normal traffic and growth NormalGenerated

16 Traffic induced by the road investment are traditionally valued at: Half the difference in transport costs Hence total generated transport cost benefits = Generated Traffic Volume x Change in Transport Costs per km x Distance x 1/2 Generated Traffic Benefits

17 Captures secondary benefits Advantages: Draws attention to changes in agricultural output (key economic activity in rural areas) Disadvantages: No reliable way of predicting response - impact studies give widely different answers - it could be based on agricultural supply price elasticities but this is almost never done; it requires very careful examination to use. For most projects benefits are just invented ! Producers’ Surplus Approach

18 Increased Farmgate Price Lower Input Costs Price & Costs per Unit of Output Output O1O2 P2 P1 Producers’ Surplus

19 Any economic analysis should be designed to give maximum coverage of benefits But we must avoid double counting. Do not add primary and secondary benefits (e.g. changes in land values added to changes in transport costs) In a competitive economy the consumers’ surplus approach (used in HDM) should be adequate Coverage and Double Counting

20 Economic analysis involves a comparison of “With” and “Without” project cases Forecasts are made of traffic, road condition, VOC and road maintenance effects for BOTH scenarios An unrealistic “Without” case (i.e. with little maintenance) can give a false result A range of “With investment” cases should be analyzed to find the best solution Economic Comparisons

21 Normal traffic: Existing traffic and growth that would occur on road, with and without the investment Diverted traffic: Traffic diverted from another road with same origin and destination to as the project road as a result of the investment Generated traffic: Traffic associated with existing users of the road driving more frequently or driving further than before Induced traffic: Traffic attracted to the project road due to increased economic activity in the road’s zone of influence brought about by the project Traffic Categories

22 Transport cost savings for existing (or normal) traffic = Normal Traffic Volume x Change in Transport Costs per km x Distance Main changes in cost from: a) change in transport MODE b) reduced journey TIME c) reduced VOCs Benefits from Road Investment

23 C1 C2 C3 T1T2T3 Traffic Costs Headloading Track Improved road Benefits of Upgrading to a Motorable Track

24 Cost Effectiveness Against Standard of Road

25 Development benefits arise from a combination of increased traffic and reduced transport costs. Benefits may also include : Increased agricultural production Increased service provision Increased industrial activity Development Benefits

26 Normal traffic benefits: trips N * d 1 * (VOC 1 - VOC 2 ) Diverted traffic benefits: trips D * ((d 1 * VOC 1 )-(d 2 *VOC 2 )) Generated and Induced traffic benefits: trips G * d 2 * (VOC 1 - VOC 2 )/2 d 1 = existing road length d 2 new road length VOC 1 = vehicle operating costs per km “without” investment VOC 2 = vehicle operating costs per km “with” investment VOC data relates to each road section and its condition at the time Estimating Benefits

27 Economic Decision Criteria (1) Net Present Value NPV = (B 1 - C 1 )/(1 + r) + (B 2 - C 2 )/ (1 + r) 2 + …+ (B n - C n )/(1 + r ) n Internal Rate of Return To calculate IRR, solve for r, such that NPV = 0 B 1, B 2 …Bn = Benefits in years 1, 2 … n C 1, C 2 …Cn = Costs in years 1, 2 …. n r = Planning discount rate n = Planning time horizon

28 Net Present Value/ Investment Cost NPV/ C = NPV/C i First Year Rate of Return FYRR = (B 1 - C 1 ) / C i B 1, C 1 = Benefits and Costs in year 1 after construction C i = Road investment costs Payback Period Economic Decision Criteria (2)

29 Economic Decision Criteria (3) NPV IRR 3 NPV/CFYRR Project economic validityV.GoodV.GoodV.GoodPoor Mutually exclusive projectsV.GoodPoorGoodPoor Project timingFairPoorPoorGood Project screening 1 PoorV.GoodGoodPoor Under budget constraint 2 FairPoorV.GoodPoor Notes: 1.check for robustness to changes in key variables (sensitivity analysis) 2.with incremental analysis 3.IRR may be indeterminate with NONE or MANY solutions.

Period Flow A0 A5 PV(A0) = A0 PV(A5) = A5 / (1 + i ) ^ 5 PV(Aj) = Aj / (1+ i ) ^ j j = Year i = Discount rate Aj = Amount at year j PV(Aj) = Present Value of Aj Present Value Calculation

in Year 1 = 1.00 Year Year Year in Year 5 = 0.64 Year Year Year Year in Year 1 0 = 0.36 in Year 1 Year in Year 20 = in in Year 1 = Present Value at 12.0% Discount Rate

32 The discount rate is opportunity cost of capital in the public sector, ie the rate of return on marginal public sector investments The discount rate to be used will be given by the planning authority responsible for the project The World Bank traditionally has not calculated a discount rate for each project but has used 10 to 15 percent as a notional opportunity cost of capital in developing countries Discount Rate

33 US discount rate around 4% Discount Rate Versus Interest Rate

34 The Net Present Value (NPV) of a project alternative relative to the without project alternative is the sum of the discounted annual net benefits. The Internal Rate of Return (IRR) is the discount rate at which the NPV is zero. NPV and IRR

35 1.If the NPV is positive, for the chosen discount rate, then the alternative is acceptable. 2.If the NPV is negative, for the chosen discount rate, then the alternative is unacceptable. 3.If the NPV is zero, for the chosen discount rate, then the alternative is indifferent to the without project alternative. NPV Decision Rule

36 NPV and IRR Calculation (1)

37 NPV and IRR Calculation (2)

38 NPV Versus IRR - The IRR and NPV will not necessarily rank the alternatives by the same order - Always use NPV to compare project alternatives

39 Multiples Rates of Return

40 No Rate of Return

41 Same Rate of Return

42 Incremental Rate of Return

43 IRR Reinvestment Assumption

44 Modified Internal Rate of Return

45 Benefits X Cost

46 Net Benefits X Costs (Efficiency Frontier)

47 Alternatives NPV When comparing project-alternatives, the Net Present Value (NPV) is used to select the optimal project-alternative (alternative with highest NPV) The Internal Rate of Return (IRR) or the B/C ratio are not recommended to compare alternatives of a given project Optimal Alternative: Highest NPV Project Comparison of Alternatives

48 When comparing the economic priority of different projects, a recommended economic indicator is the NPV per Investment ratio Projects Selected Alternative Overlay Reseal Overlay NPV/Investment PRIORITYPRIORITY Ranking Projects

49 Projects Selected Alternative Overlay Reseal Overlay Reseal Overlay NPV per Investment PRIORITYPRIORITY NPV Investment Available Budget Budget Constraints Simple Methodology Budget Constraint Cut Off

50 Projects Alternatives Available Budget Budget Constraints Optimization Evaluates all possible combinations of project- alternatives to find the combination that maximizes the NPV of the overall network for the given budget constraint. P = Number of projects A = Number of alternatives C = Number of possible combinations C = A ^ P NPV

51 OptionNPVCost A 4 2 B 7 5 C 8 7 OptionNPVCost A 3 1 B 6 3 C 8 5 Section 1 Section 2 HDM-4 Optimization Example (1) What is the recommended program for a budget of 5?

52 dNPV/dCost HDM-4 Optimization Example (2)

53 HDM-4 Optimization Example (3) Combination of project alternatives that maximizes the NPV of the network

54 An Appraisal is carried out before an investment is made. Everything is uncertain. A Post evaluation may be made say 5 years after the investment. The investment is known and 5yrs of with case are known. The without case is unknown as is the remainder of the with case. Appraisals & Post Evaluations (1)

55 In Both Cases forecasting and evaluation models are required to come to an answer. Hence we can never be certain about the viability of an investment ! Appraisals & Post Evaluations (2)

56 Consequences of changes on inputs Investment Costs (e.g. +15%) Traffic Growth Rate (e.g. = zero) Generate Traffic (e.g. = zero) Value of Time (e.g. = zero) A = Investment Costs Increase (e.g. +15%) B = Road User Benefits Decrease (e.g. - 15%) C = A and B together Sensitivity Analysis

57 Inputs that yield a NPV equal to zero Investments Costs Normal Traffic Traffic Growth Rate Generate Traffic Investment Cost Road User Benefits Switching Values Analysis

58 Risk Analysis Inputs vary at the same time following some defined distributions

59 Rural Transport Infrastructure “Tracks”“Roads”“Highways”

60 Rural Transport Infrastructure Focus on social evaluation (cost effectiveness indices, community priorities and multi-criteria analysis)

61 Social Benefits: Why the Concern ? There is unease with conventional appraisal based primarily on transport cost savings to traffic There is a strong desire at community and national levels for better access and mobility which is frequently not matched by standard measured economic benefits The ‘rich’ world governments subsidise rural transport. Should the same happen for developing countries ? Isolation is a recognised characteristic of poverty There is a feeling that a minimum degree of access and mobility is a ‘basic human right’ Development has moved away from a narrow definition of economic development towards concern with ‘livelihoods’ and meeting ‘Millennium Development Goals’ The issue is particularly important when roads are impassable to motor traffic

62 Economic & Social Benefits Consumers and producers surplus approaches are very economic in orientation. Yet roads provide ‘social benefits’ – including improved access to health and education facilities and improved social mobility that cannot be easily translated into conventional economic benefits. – Although they may have important long term ‘economic’ consequences. Improved health and education and more secure social networks increase long term earning capabilities but so far the economic forecasting framework does not include this. When roads are impassable to motorized traffic we know that the quality of health care and schooling falls. Drug supply and supervision drops. Likewise no NGO, government agency or commercial enterprise will establish or support a service which cannot guarantee all year round access.

63 Widely used for feeder road planning; there are many different approaches e.g. i) cost of improvement / population ii) estimated trips / cost Advantages: Speed, simplicity, transparency, many factors can be incorporated Disadvantages: How do we value widely different factors ? (adding up apples and pears); weightings are not stable ; cannot easily address questions of road standards, timing etc, ; possible double counting Indices and Ranking

64 Example of Two Indices i) Andhra Pradesh (India) cost effectiveness = cost of upgrading/ population served But – no measure of condition change and no importance to traffic ii) Airey & Taylor 1st for impassable roads rank = cost per head of establishing basic access 2nd when access is there: estimated trips x access change prioritization index = rehabilitation cost per km

65 Community priorities now often form an important part of feeder road appraisal. It is possible just to ask communities to rank the investments they prefer- both within the road sector or between roads and other investments. Advantages: Community acceptability, use of community knowledge Disadvantages: Sectional interest groups may dominate voting, community knowledge of area or road impact may be poor Community Priorities

66 Cost Effectiveness Analysis (CEA) Compares the cost of interventions with its predicted impacts and it is used where the benefits cannot be measured in monetary terms, or where the measurement is difficult It includes provisions that (a) the objectives of the intervention are indicated and are clearly part of a ampler program of objectives (such as reduction of the poverty); and (b) the intervention represents the smaller cost alternative of obtaining the indicated objectives It produces effectiveness indicators, such as Total Beneficiary Population per Investment or Investment per Beneficiary Population

67 Alternatives Investment CEA Comparison of Alternatives To compare project-alternatives, the investment cost is used to select the optimal alternative The selected alternative is the one with the lowest investment cost that will achieve the objective of the program Optimal Alternative: Lower Investment Project

68 Projects Eligibility with CEA To assess if a project is eligible, an acceptable effectiveness indicator threshold is defined Projects Investment per Population (U$/person) Eligible Not Eligible Effectiveness Indicator Threshold Example

69 Effectiveness Indicator Threshold Evaluate Universe of Projects and Available Budget

70 Possible CEA Indicators Investment Cost per Total Beneficiary Population 100 US$ per person Total Beneficiary Population per Investment Cost 0.01 persons per US$ Total Beneficiary Population per Investment Cost in thousands of dollars 10 persons per 1,000 US$ Etc.

71 Options for Beneficiary Population Rural beneficiary population o Effectiveness = (rural beneficiary population) / Investment Poor beneficiary population o Effectiveness = (poor beneficiary population) / Investment Mixed beneficiary population o Effectiveness = (poor persons non poor persons) / Investment Etc.

72 Total Beneficiary Population (1) Total Beneficiary Population = Directly Benefited Population + Indirectly Benefited Population The Directly Benefited Population is the one that lives next on the road, defined for example to 2.0 km at each side of the road, and the population in the ends of the road, depending on its characteristics and the use of the road The Indirectly Benefited Population is the population that lives in other roads near the road in consideration, who use the project road to arrive at the main population center of the region or at a main road

73 Total Beneficiary Population (2) For example, for the road section B-C: Directly Benefited Population = Population along section B-C plus on towns B and C Indirectly Benefited Population = Population along section A-B plus on town A

74 Multi Criteria Analysis (MCA) (1) It adopts criteria such as traffic, proximity to educative, health, and economic centers, etc. To each section, a number of the points is assigned to each criteria that correspond to the fulfillment of the criteria The added number of the points that each section receives is computed simply adding the points assigned for each criteria, or with the use of a more complex formula, for example, weighting the criteria by their perceived importance

75 Multi Criteria Analysis (2) It produces a priority indicator The indicators used in a MCA reflect implicit economic and subjective evaluations If the weights and the points are decided and assigned on a participative way, the MCA has the potential to be a good participative method for planning based on implicit a socioeconomic estimates Nevertheless, it tends to be applied by planning consultants or in isolation without the consultation with the users and communities affected by the project

76 Multi Criteria Analysis (3) The result of the MCA, is often, unfortunately, not transparent, specially if many factors are considered and a complicated formula is also applied Therefore, if it is adopted, this method must be used very carefully and to be maintained simple, transparent, and participative

77 Multi Criteria Analysis Example (1) Level of poverty of the influence area (Low, Medium, High) Potential for economic development of the influence area (Low, Medium, High) Importance of the road given by local consultation process (Low, Medium, High) Provision of access of social services of the road (Low, Medium, High) Problems of transitability of the road (Low, Medium, High) Functional classification level of the road (Low, Medium, High) Existence of public transport (Low, Medium, High)

78 Multi Criteria Analysis Example (2) Factor = Value / Maximum Value