EVALUATION OF INFRASTRUCTURE
INVESTMENTS2
CONTENT
• FOCUS
• CONTEXT
• FRAMEWORKS
• CONCEPTS
• EXTERNALITIES
• UNCERTAINTY/RISK
• EMERGING ISSUES
• CASE STUDIESFOCUS
To introduce principles, concepts and methods for
evaluating infrastructure-project investments
Emphasis
• Infrastructure
• Evaluation
3Focus (contd.)
• Infrastructure
- definition
- significance
• Evaluation
- assessment of worth
- worth?
45
INFRASTRUCTURE-PROJECT EVALUATION: THE CONTEXT
INFRASTRUCTURE
PROJECTS
MAGNITUDE OF
INVESTMENTS
RESOURCE
SCARCITY
LONG
GESTATIONS
SOURCES OF
FINANCING
POLICY
SETTINGS
INTER- & INTRASECTORAL
LINKAGES
SEVERAL
DECISION
MAKERS
MULTIPLE
CONFLICTING
OBJECTIVES
VALUATION
PROBLEMS
COMMENSURABILITY
PROBLEMS
RISK &
UNCERTAINTY
ENVIRONMENTAL
CONSIDERATIONS
SEVERAL
IMPACTED
GROUPS
OPTIONS WITH
CONTRASTING
IMPLICATIONSMAGNITUDE OF INVESTMENTS
According to OECD/IEA (2003):
“The total investment requirement for energy-supply
infrastructure worldwide over the period 2001-2030 is $16
trillion.”
“…electricity sector dominates the investment…will absorb
almost $10trillion, …oil and gas sectors will each amount to
more than $3 trillion, …coal industry requires almost $4000
billion…”
“…developing countries…require almost half of global
investment in the energy sector…China alone will need to
invest $2.3 trillion, …$1.2 trillion in Africa and $1 trillion in
the Middle East…”“…51% of investment in energy production will be needed
simply to replace or maintain existing and future
capacity…share of investment is highest for oil
upstream (78%), followed by gas upstream (70%), coal
mining (65%)…power plants (30%)…remaining 49%
will be in capacity to meet rising demand.”
“…extraction costs, including those incurred in exploring
for reserve, will account for most of the investment in
the fossil-fuel industry…mining will absorb 88% of
total coal investment…exploration and development
will take nearly three-quarters of total investment in
oil…”
Investments: A Broad Overview (contd.)Total* Investments in Electricity
Notes: 1) * 2012 US dollars; includes generation, T&D
2) F-fossil, N-nuclear, H-hydro, R-renewables, T&D-Transmission and Distribution
3) # Latin America
Source: IEA (2014) World Energy Investment Outlook
2000-13 2014-25 2026-35
Total F N H R T&D Total F N H R T&D Total F N H R T&D
$ bn Percentages $ bn Percentages $ bn Percentages
OECD 3,066 19 2 5 32 43 2,860 15 7 5 38 36 2,541 14 6 5 45 30
USA 973 25 0 1 20 54 939 18 4 3 34 41 850 20 5 3 39 33
Europe 1,335 14 0 5 49 32 1,119 12 8 6 42 31 1,032 9 7 6 52 25
Other 758 19 6 8 18 50 802 17 7 6 35 35 659 12 8 7 40 33
Non-OECD 3,166 26 2 17 11 45 4,671 19 8 13 17 44 4,181 18 6 12 23 42
China 1,345 32 2 21 14 31 1,887 12 10 11 22 45 1,196 11 7 5 30 47
India 416 23 1 9 12 54 649 24 6 10 21 39 761 22 4 12 23 39
ASEAN 274 23 0 12 9 56 392 24 2 10 11 52 451 25 2 11 10 53
Africa 151 19 0 10 4 67 352 23 2 13 13 48 414 19 3 15 20 42
LA# 296 9 1 36 14 40 429 8 2 30 12 48 369 8 2 29 20 41
World total 6,232 22 2 11 21 44 7,531 17 7 10 25 41 6,722 16 6 9 31 372000-13 2014-25 2026-35
Total F N H R Total F N H R Total F N H R
$ bn Percentages $ bn Percentages $ bn Percentages
OECD 134 33 3 8 56 167 23 10 8 58 197 19 9 8 64
USA 34 54 0 3 43 50 30 7 5 58 63 30 7 5 58
Europe 70 20 0 8 72 70 17 12 9 62 86 12 9 8 70
Other 29 37 11 16 35 47 26 12 9 54 49 17 12 11 60
Non-OECD 134 47 3 31 19 240 33 14 23 30 270 31 10 20 39
China 72 46 3 31 20 95 22 18 20 39 70 21 13 9 57
India 15 50 3 19 27 36 39 9 17 35 52 36 6 20 37
ASEAN 9 51 0 28 21 17 51 5 22 22 24 53 4 23 20
Africa 4 58 0 30 12 17 44 5 26 26 27 33 5 26 35
LA# 14 15 1 60 24 20 15 5 57 23 24 14 3 49 34
World total 268 40 3 19 38 407 29 12 17 42 467 26 10 15 50
Investments in Generation (Average Annual)
Note: 1) 2012 US dollars
2) F-fossil, N-nuclear, H-hydro, R-renewables
3) # Latin America
Source: IEA (2014) World Energy Investment Outlook10
INFRASTRUCTURE-PROJECT EVALUATION: THE CONTEXT
INFRASTRUCTURE
PROJECTS
MAGNITUDE OF
INVESTMENTS
RESOURCE
SCARCITY
LONG
GESTATIONS
SOURCES OF
FINANCING
POLICY
SETTINGS
INTER- & INTRASECTORAL
LINKAGES
SEVERAL
DECISION
MAKERS
MULTIPLE
CONFLICTING
OBJECTIVES
VALUATION
PROBLEMS
COMMENSURABILITY
PROBLEMS
RISK &
UNCERTAINTY
ENVIRONMENTAL
CONSIDERATIONS
SEVERAL
IMPACTED
GROUPS
OPTIONS WITH
CONTRASTING
IMPLICATIONS11
Project Evaluation: Context (contd.)
• consideration of several exogenous and
endogenous factors
• a framework which provides a satisfactory
redress of issues associated with these factors
A review of features that typify infrastructure
projects suggests that evaluation requires:12
PROJECT EVALUATION FRAMEWORKS
• FINANCIAL EVALUATION
- investor perspective
• ECONOMIC
- broader economy-wide perspective
• POLITICAL
- socio-political perspective
• PHILOSOPHICAL
- ‘introspective’ perspective
• SPIRITUAL
- ‘metaphysic’ perspective13
CONCEPTS
• COSTS/BENEFITS
- conventions
- identification
- valuation
• TIME VALUE OF MONEY
- interest and discount rates
- future and present values
• EVALUATION
- viability indicators
- decision criteria14
Capital Costs
PROJECT
ESTABLISHMENT
t = 0
USEFUL (ECONOMIC)
LIFE OF THE PROJECT
Operating Costs
COSTS
CAPITAL COSTS
(Generally, only
Initially)
OPERATING
COSTS
(Annual)
Fixed Variable
I
0 : Capital costs
C1: Capital cost for year 1
C
n: Capital cost for year n
COSTS/BENEFITS: CONNECTIONS
Concepts (contd.)
Project
conception/feasibility
planning/design/
establishment/construction
(pre-operative costs)
Operation, maintenance &
other incidental expenses
I
0
C
1 C2 … Cn15
Concepts (contd.)
PROJECT LIFE SPAN
B
1 B2 Bn
L
n
BENEFITS
B
1, B2…Bn: Annual Benefits
L
n:
Liquidation Yield/Salvage Value
CASH-FLOW
(Benefits-Costs)/Period of Time (typically annual)
I
016
CONCEPTS
• COSTS/BENEFITS
- conventions
- identification
- valuation
• TIME VALUE OF MONEY
- interest and discount rates
- future and present values
• EVALUATION
- viability indicators
- decision criteria17
TIME VALUE OF MONEY
• MONEY HAS TIME VALUE!
WHY?
VALUE-IN-USE INFLATION/DEFLATION
(other economic Forces)
PRESENT INVESTMENT
CONSUMPTION (Future Consumption)18
Time Value of Money (contd.)
• Implications: money amounts happening at different
points in time cannot be directly combined and
compared
• Interest/discount rates are used to account for the
time value of money
• These rates reflect the opportunity cost of money in a
particular situation19
• COMPOUNDING INTEREST
RATES
• DISCOUNTING DISCOUNT
RATES
TIME VALUE OF MONEY
Time value of money (contd.)20
INTEREST AND DISCOUNT RATES
These rates account for the change in the value of money over
time
EFFECTS OF INFLATION AND ESCALATION
INFLATION
Refers to rise in price levels caused by a decline in the
purchasing power of money
ESCALATION
Also refers to rise in prices (but) due to the nature (in
particular, its scarcity) of the resource
REAL ESCALATION RATE
Escalation over and above the general rate of inflation21
APPARENT ESCALATION RATE
(1 + i) = (1 + i′)(1 + f)(1+e)
where
i = Apparent discount (interest) rate
i′ = Opportunity cost/ real discount/interest rate
f = Inflation rate
e = Escalation rate
• REAL (CONSTANT) and NOMINAL (CURRENT)
INTEREST/ DISCOUNT RATES
• EFFECTIVE DISCOUNT RATES22
FUTURE VALUE OF MONEY
SINGLE AMOUNT FUTURE VALUE
F
A A(1+i) A(1+i)2
1 2 3 n
YEARS
F = A (1+i)n
A = Initial amount
i = Interest Rate
n = Time period
F = Future value
Single payment
compound
amount factor23
Future Value of Money (contd.)
UNIFORM SERIES FUTURE VALUE
(Assumption: 10% Interest Rate)
t = 0
1 2 3
1 1 1
Years
4 5
1 1
1(1+0.1)1
1(1+0.1)2
1(1+0.1)3
1(1+0.1)4
1
1.1
1.21
1.33
1.46
$6.10m
($Mn)24
For n time periods
F = A + A (1 + i)1 + .... + A(1+i)n-1
Future Value Interest
Factor for an Annuity
(for n years; at i rate of interest)
OR
Uniform Series Compound
Amount Factor
OR (Simply)
Future Value Factor
F = Future value of annuity
n = Duration of the annuity
i = Interest Rate
A = Annuity
( )
n
1+i -1
F = A = A (FVIFA )
i i,n
Future Value of Money (contd.)25
• SINKING FUND
A fund established to accumulate a desired future amount
of money at the end of a given length of time through the
collection of a uniform series of payments
-
i
A = F
n
1+i 1
Sinking Fund Factor26
PRESENT VALUE OF MONEY
SINGLE AMOUNT PRESENT VALUE
UNIFORM SERIES PRESENT VALUE
A
P =
n
(1+i)
t = 0
1 2 3
1 1 1
$Mn
1
(1+0.1)1
1
(1+0.1)2
1
(1+0.1)3
0.9
0.83
0.75
$2.48 Mn
n
P = A (1+i) -1
n
i (1+i)
PVIFA i, n
Present Value Factor
Present Value
of an annuity (A)
which has a duration
of n periods27
Present Value of Money (contd.)
• CAPITAL RECOVERY FACTOR
A = P i (1+i)n
(1+i)n −
1
Capital Recovery Factor
Amount of each annual payment made for n years
in order to repay a debt P at i rate of interest
• PRESENT VALUE OF AN UNEVEN SERIES
• PERPETUITIES
∑
A A A
PV = + + . . . . . . + 1 2 n
(1+i) (1+i)2 n (1+i)
n A
t
=
t =1 (1+i)t
Present value of an annuity for an infinite
number of years (that is, perpetuity)28
INTEREST/DISCOUNT RATES – REVISITED
• Project evaluation can be carried out by either including
or excluding inflation effects
• If effects of inflation are included
=> evaluation in nominal (current) terms
• If effects of inflation are excluded
=> evaluation in real (constant) terms
• It is suggested that long-term project evaluation be carried
out in real terms.
Why?29
PROJECT VIABILITY INDICATORS
• NET PRESENT VALUE (NPV)
• INTERNAL RATE OF RETURN (IRR)
• PAY BACK PERIOD (PB)
• BENEFIT-TO-COST RATIO (BCR)
• ANNUAL CAPITAL CHARGE/EQUIVALENT
ANNUAL CHARGE (EAC)
• LIFE CYCLE COST (LCC)30
I0
Years
1 2 3
C1 C2 C3 Cn
B1 B2 B3 Bn, Ln
NET PRESENT VALUE
Sum of the present values of all cash-flows associated with a project
C
1 = C2 = … = Cn (B1 – C1) = (B2 – C2) = … = (Bn – Cn) = (B – C)
B
1 = B2 = … = Bn
PRESENT VALUE FACTOR
1 1 2 2 n n n
0 2 n n
(B - C ) (B - C ) (B - C ) L
NPV = - I + + + ... + +
(1+ i) (1+ i) (1+ i) (1+ i)
n
0 2 n n
1 1 1 L
NPV = - I + (B -C) + + ...+ +
(1+ i) (1+ i) (1+ i) (1+ i)
n
0 i,n n
L
NPV = -I +(B -C)PVF +
(1+ i)
t = 031
Net Present Value (contd.)
• CRITERIA
- Positive NPV => Project Viable
- NPV (Option I) > NPV (Option II)
=> Option I preferable
• FEATURES OF NPV
- Considers time value of money
- $ profits/absolute measure
- Influenced strongly by discount rates
- Not particularly useful for comparing projects with unequal
economic life-spans32
NPV V DISCOUNT RATES
PROJECT A
PROJECT B
NPV
+
_
i
1 i2 i3 i
Net Present Value (contd.)
033
Net Present Value (contd.)
• CRITERIA
- Positive NPV => Project Viable
- NPV (Option I) > NPV (Option II)
=> Option I preferable
• FEATURES OF NPV
- Considers time value of money
- $ profits/absolute measure
- Influenced strongly by discount rates
- Not particularly useful for comparing projects with unequal
economic life-spans34
PROJECT WITH UNEQUAL ECONOMIC LIFE-SPANS
(Ref. SAMSON, 1989)
$20,000
PROJECT A $6,000/yr
0 Years 10
$20,000
PROJECT B $5,000/yr
0 Years
NPVA (8%, 10 Years) = $20,261
NPVB (8%, 15 Years) = $22,798
15
PREFERABLE35
contd.
PROJECT A
$20,000 $20,000 $20,000
10 10 10
0 Years 30
$6,000/yr
PROJECT B
$20,000 $20,000
15 15
0 Years 30
$5,000/yr
NPVA = - 20,000 (1 + PVF8, 10 + PVF8, 20) + 6,000 PVF8, 30
NPVA = $33,992
NPVB = $29,984
PREFERABLE36
INTERNAL RATE OF RETURN (IRR)
Discount rate at which NPV equals zero
NPV = - Io + (B - C) PVF i, n + Ln/(1 + i)n
i = discount rate at which NPV = 0
1 1 2 2 n n n
0 2 n n
(B - C ) (B - C ) (B - C ) L
0 = - I + + + ... + +
(1+ i) (1+ i) (1+ i) (1+ i)
IRR
NPV
+ 0 _
i
IRR IRR (approximation)
(i2 – i1)
IRR = i – NPV
1 1
NPV
2 – NPV137
IRR (contd.)
• CRITERIA
- IRR > specified /acceptable rate of return
- IRR (Option I) > IRR (Option II)
=> Option I preferable
• FEATURES
- Practical
- Obviates the need to select discount rate prior to analysis
- Liable to give multiple rates of return, especially for
projects with large expenditures at both the beginning and
end of economic lives
- Could provide misleading indication when comparing
projects with significantly different capital outlays38
PROJECT WITH MULTIPLE RATES OF RETURN
$18000
+$45000
Annual cash flow $4000/yr
NPV
+ _
0
Discount rate (%)
IRR = 2%
IRR =14.7%
1 2 3 4 . . . . . .
2 4 6 8 10 12 14 16
IRR (contd.)39
IRR (contd.)
• CRITERIA
- IRR > specified /acceptable rate of return
- IRR (Option I) > IRR (Option II)
=> Option I preferable
• FEATURES
- Practical
- Obviates the need to select discount rate prior to analysis
- Liable to give multiple rates of return, especially for
projects with large expenditures at both the beginning and
end of economic lives
- Could provide misleading indication when comparing
projects with significantly different capital outlays40
PROJECT WITH SIGNIFICANTLY DIFFERENT CAPITAL OUTLAYS
CASH FLOWS IRR NPV ($)
0 ($) 1 (%) (n = 2 Yrs; i = 12%)
PROJECT I -10000 20000 100 7857
PROJECT II -50000 75000 50 16964
NPV => Project II preferable
IRR => Project I preferable
=> IRR is unsuitable for ranking projects with significantly different outlays
=> A re-constituted ‘IRR’ on incremental capital outlays
INCREMENTAL FLOWS ($)
0 1 IRR (%)
Desirability of -40,000 55,000 37.5
a switch from
low outlay
project to a
high outlay project
IRR (Incr. flows) > Cost Of Capital (12%)
=> Desirable to switch from Project I II
IRR (contd.)41
PAYBACK PERIOD (PB)
• Time required to recover initial cash outlay on the project
PB = capital invested (years)
annual return
• STATIC PAYBACK PERIOD
DYNAMIC PAYBACK PERIOD
• FEATURES
- Simple/widely used
- Favours projects which generate substantial cash
inflows in the earlier years (and discriminates against
projects which bring substantial benefits in the later
years, of project life)42
Cash Flows ($)
Project 0 1 2
Years
3 4 NPV
(8%)
PB
(YRS)
A -3000 1000 1000 1000 4000 2331 3
B -3000 0 0 3000 4000 2150 3
C -3000 0 0 1000 10000 4763 4
Ref: Dept of Finance, 1991
PB (contd.)43
BENEFIT-COST RATIO
• BCR =
• FEATURES
BCR rule is liable to give incorrect ranking if
projects differ in size
Present value of benefit
Initial investment (or PV of costs)44
EXAMPLE
PROJECT PV COSTS PV BENEFITS NPV BCR
($Mn) ($Mn) ($Mn)
A 1.0 1.3 0.3 1.3
B 8.0 9.4 1.4 1.2
C 1.5 2.1 0.6 1.4
If projects are ranked according to their benefit-cost ratios,
we would select Project C. However, in terms of NPV,
Project B is best
BCR (contd.)45
- BCR is sensitive to the way in which costs have been
defined in setting out cash flows
EXAMPLE (Ref: Dept of Finance, 1991)
PROJECT A PROJECT B
PV Benefits 2000 2000
PV Operating Costs 500 1800
PV Capital Costs 1200 100
NPV (300) (100)
BCR 2000 – 500 2000 – 1800
1200 100
RECOMMENDED
Also
BCR 2000 2000
1700 1900
RECOMMENDED
BCR (contd.)46
ANNUAL CAPITAL CHARGE (ACC)
(Equivalent Annual Cost; Annualised Cost)
Cost on an annual basis of the initial outlay and operating costs
associated with an investment
• EXAMPLE
YEAR $
0 initial outlay 1000
1 200 x 0.9091
2 250 x 0.8264
3 operating costs 300 x 0.7513
4 350 x 0.6830
5 400 x 0.6209
PV COSTS = $2117
EAC = 2117 x Capital Recovery Factor
(n = 5, i = 10%)47
ACC (contd.)
• CRITERIA
EAC (Option I) > EAC (Option II)
=> Option II preferable
• FEATURES
- Helpful in selecting between alternatives which
provide similar services but have different patterns
of costs; such alternatives often have unequal project lives
- Used in public price regulation, for example, electricity
utilities48
LIFE CYCLE COST (LCC)
C C C
PV(LCC)=I + + + . . . + 1 2 n
0 (1+i) (1+i) (1+i) 2 n
CRITERIA
LCC (Option I) > LCC (Option II)
Option II preferable
YEARS
……
C1 C2 Cn
I
049
PROJECT EVALUATION FRAMEWORKS
• FINANCIAL EVALUATION
- investor perspective
• ECONOMIC
- broader economy-wide perspective
• POLITICAL
- socio-political perspective
• PHILOSOPHICAL
- ‘introspective’ perspective
• SPIRITUAL
- ‘metaphysic’ perspective50
FINANCIAL EVALUATION
• Investor perspective
• Emphasis: cost minimisation/profit maximisation
• Costs/benefits assessed at market prices
• Interest (discount) rate
Market interest (discount) rate
• Monetary considerations dominate51
RATIONALE FOR ECONOMIC EVALUATION
• MARKETS, MARKET PRICES, ALLOCATIVE
EFFICIENCY
- markets
- allocative efficiency
- competitive markets
- market distortions52
MARKETS AND ALLOCATIVE EFFICIENCY
PRICE
QUANTITY
MC
DEMAND
P
CS
PS
TC
Q53
MARKETS AND ALLOCATIVE EFFICIENCY
PRICE
P
Q
SUPPLY (MC)
DEMAND
QUANTITY
QUANTITY
Q
P
PRICE
MC
DEMAND
P > MC
P < MC
QUANTITY
DEMAND
MC
PRICE
P
Q
P = MC54
Rationale for Economic Evaluation (contd.)
MARKET FAILURES
Market
Distortions
(Imperfections)
Absence of market
- Public goods
- Externalities
- Natural monopolies
- Concern for income distribution/savings
- Wider-impacts (jobs, foreign trade, …)
ECONOMIC EVALUATION
Origins of economic evaluation: Welfare Economics
These features are typical for all infrastructure projects
...55
METHODOLOGY OF ECONOMIC EVALUATION
Identify Project
Objectives
Identify Options
Identify
Costs/Benefits
Quantify/Value Costs/Benefits
Calculate Viability
Sensitivity Analysis
Consider
Qualitative Aspects
Compare
Options/Select
Base Case Scenario
Costs/Benefits
Tangibles Intangibles
Shadow Pricing
Indicators of Viability
Intangibles
Decision criteria56
IDENTIFICATION OF INPUTS (COSTS)
AND OUTPUTS (BENEFITS)
• Inputs Project Outputs
(Costs) (Benefits)
• Infrastructure projects is likely to affect the availability of inputs and
outputs for others
• Typical effects
– allocative
– distributional
• General Rules: Economic Evaluation
– include all costs/benefits which have allocative effects
– exclude economic transfers
• Costs/benefits are identified and valued on the basis of ‘with and
without’/‘incremental’ principle
• Costs: ‘proportional’ effects
• Benefits: additionality, resources releasedEXAMPLE: Shifting Load Duration Curves
and Addition to Capacity
A
B
C
kw
p1
p0
p1 - p0
Q1
Q0
8760
hrs/day58
VALUATION OF COST/BENEFITS
• MARKET IMPERFECTIONS
=> Market prices ≠ Social prices
=> - ‘Adjustments’ to market prices
- Method for quantification of intangibles
• SHADOW PRICES
SHADOW PRICING
• CONCEPTUAL BASIS FOR SHADOW PRICING
– Opportunity Cost Principle
– Willingness to Pay CriteriaNET OUTPUT (benefits)
Additionality
of supply
Resources released
from alternative sources
of supply
Type of change of
energy demand
Type of market
influenced by the
additionality
Marginal
change in
demand
Discrete
change in
demand
Existing
Market
New of
induced
market
Consumers
Switch from
one source of
energy to another60
OPPORTUNITY COST IN EFFICIENT FACTOR MARKET
Po
a b
Qo Qo + Q’
MC
PRICE PRICE
D
D
D + Q’
P1
Po
Q’
d
Q1
e
c
f h
S
g
Q2 Qo
Quantity/Time Quantity/Time
(a) Constant marginal cost
(perfectly elastic supply)
(b) Rising marginal cost
(upward sloping supply schedule)
Public expenditure
exactly equals the
opportunity cost
of using q’ units of
the factor for the
project
Opportunity cost
equals expenditure
less (plus) any increase
(decrease) in social
surplus occurring in the
factor market itself
Opportunity cost ≠ Expenditure on
purchase of Q’ units of inputs for
the project
Net gain in social
surplus61
INEFFICIENT MARKETS
WAGE
Wm
Wo
D+L’
D
a b
d c
S
Ld Lt Lo Lm
Total expenditure on labor: Wm.L’ (abLtLd)
Producer surplus: abcd
Opportunity cost: dc Lt Ld
Opportunity cost equals expenditures on the factor minus (plus)
gains (loses) in social surplus occurring in the factor market62
WILLINGNESS TO PAY
Q
c b
a
P e d
1
Po
q2 q1
D
S+Q
S
q0
Consumer Surplus: PoabP1
Loss of Producer Surplus: PoacP1
Net change in Social Surplus: abc
Total benefit = abc +Revenue(q2cbq1)
Social surplus change:
a) Direct supply of Q by Project: Gain of triangle abc plus project revenue equal to
area of rectangle q2cbq1
b) Supply schedule shift through cost reduction: Gain of trapezoid abde
PRICE EFFICIENT MARKET63
WILLINGNESS TO PAY
P1-V
Po
P1
q0 q1
e
d
c
b
a
S S-V
Ds
DM
Supply schedule as
a result of the
availability of vouchers
Social demand schedule
(Poqo) too low from social perspective
Market
demand schedule
SOCIAL BENEFIT
OF ENERGY
EFFICIENCY
IMPROVEMENT
PROGRAM?
($V Per unit of
energy reduction
through efficiency
improvement)
V
Quantity/Time
Gain to consumer in target neighborhood: Podc(P1-V)
Gain to consumer in nearby neighborhoods: abcd
Gain to producer: P1edPo
Program cost: P1ec(P1-V)
Net benefit: abed (Gain in
social surplus -program cost)
Area
between the
market &
Social
demand
schedules
over the
increase in
consumption
DISTORTED MARKET
(e.g. Energy Efficient Program)64
EXTERNALITIES
• Unintended consequences on ‘third party’
• Quantification
– Related market (hedonic price)
– Hypothetical market (contingent valuation)
– Dose-response65
EXTERNALITY: SOCIAL WELFARE LOSS
O Q” Q
C B
D
A
E
PF
P”
P’
G
PRICE (COAL)
SMC
PMC
EFFECT OF
EXTERNALITY
Q : MARKET BASED
OUTPUT
Q” : SOCIALLY DESIRED
OUTPUT
QUANTITY ( COAL)
OUTPUT Q”
SOCIAL COSTS OF PRODUCTION : OFDQ”
SOCIAL BENEFITS : OGDQ”
NET SURPLUS : GDF
OUTPUT Q
SOCIAL COST OF PRODUCTION : OFBQ
SOCIAL BENEFITS : OGAQ
NET SURPLUS : SOCIAL SURPLUS GDF
SOCIAL WELFARE LOSS BAD
ADJUST MARKET PRICE ‘TAX’66
OPTIMUM LEVEL OF POLLUTION
& POLLUTION TAX
HIGH NET SOCIAL COSTS
FROM
TOO MUCH
CONTROL
TOO LITLE
CONTROL
TOTAL COSTS
O Z X Y
A
E
D
COMPLETE NO
CONTRO L POLLUTION LEVEL CONTROL
OY : UNCONTROLLED POLLUTION
OX MAC = MDC OPTIMUM LEVEL OF POLLUTION.
EX : POLLUTION TAX
COSTS67
TRADABLE PERMITS
PRIVATE
MARGINAL
COST OF
ABATEMENT
SOURCE A
PRIVATE
MARGINAL
COST OF
ABATEMENT
SOURCE B
MCB MCA
E
B A
P * P *
O Q’ Q* F
EMISSIONS
REDUCTION
SOURCE A
EMISSIONS
REDUCTION
SOURCE B68
UNCERTAINTY AND RISK ANALYSIS
• UNCERTAINTY AND RISK – UBIQUITIONS
• TECHNIQUES FOR HANDING UNCERTAINTY
– Sensitivity analysis
– Risk analysis
– Loading the discount rate69
SENSITIVITY ANALYSIS
How does the value of a viability indicator change when an
input parameter deviates by a certain amount from the
estimated value?70
SENSITIVITY ANALYSIS (CONTD.)
EXAMPLE REF.: ADOPTED FROM FINCK/ OELERT
(1985)
PROJECT OPTIONS
Parameters Option I
(Small-Hydro)
Option II
(Diesel)
Investment 540000 87000
Annual Cost
- Salaries
- Repair
- Fuel
- Administration
16000
18900
-
5000
16000
14400
105000
5000
Energy Sold (Units per year) 350000 350000
Selling Price (Cents/Unit) 0.50 0.50
Salvage Value ($) - 10000
Discount Rate (%) 8 8
Economic Life (Year) 25 7
NPV ($) 902400 9897571
SENSITIVITY ANALYSIS(CONTD.)
OPTION I
NPV $902400
Note : ( ) negative value
* Most sensitive parameters
** Least sensitive parameter
Input parameters Chang in NPV Sensitivity
Ranking
+10% -10%
Investment (74413) 73938 III
Salaries (173170) 16842 VI
Repair (20413) 19938 V
Administration (5575) 5100 VII**
Energy sold 185571 (187046) I
Selling Price 186571 (187046) I
Discount rate (93675) 104035 II
Economic life 42921 (52554) IV
Salvage Value - - -
*72
SENSITIVITY ANALYSIS(CONTD.)
OPTION II
NPV $98975
Note : ( ) negative value
* Most sensitive parameters
** Least sensitive parameters
Input parameters Chang in NPV
(Input)
Sensitivity
Ranking
+10% -10%
Investment (8117) 8116 IV
Salaries (8330) 8331 V
Repair (7497) 7498 VII
Fuel (54666) 54667 II
Administration (2603) 2604 IX**
Energy sold 36445 (36444) III
Selling Price 91112 (91111) I*
Discount rate (5119) 5348 VIII
Economic life 12930 (13645) IV
Salvage Value 583 (584) X**73
SENSITIVITY ANALYSIS (CONTD.)
CRITICAL VALUES / SWITCHING VALUES
• Maximum/Minimum acceptable values of Input Parameters
(Acceptable range of uncertainty)
• Example
NPV = - Io + (B - C ). PVF i, n
Io = ( B - C ) . PVF i, n
• CRITICAL / SWITCHING VALUE
Value of the variable at which NPV changes from positive to negative74
SENSITIVITY ANALYSIS (CONTD)
CRITICAL SWITCHING VALUES
Input parameter Option I
NPV= $902400 NPV= 0
Expected value Critical value
Option II
NPV= $98975 NPV= 0
Expected value Critical value
Investment ($) 540000 1442162 87000 185975
Salaries ($) 16000 100513 16000 35010
Repair ($/year) 18900 103413 14400 33410
Fuel ($/year) - - 105000 124010
Administration
($/year)
5000 89513 5000 24010
Sale (Units) 350000 180974 350000 254950
Sale price
(Cents/unit)
0.5 0.26 0.5 0.45
Salvage value ($) - - - -
Discount rate
(%)
8 24.9 8 35.8
Economic life
(years)
25 5 7 2.675
Example: Sensitivity Analysis
-60 -50 -40 -30 -20 -10 0 +10 +20 +30 +40 +50
NPV
$
CRITICAL VALUE
OF FUEL COSTS
CRITICAL VALUE
OF SELLING PRICE
100000
_ 20000
_60000
200000 _
% CHANGE IN PARAMETERS76
RISK ANALYSIS
• SENSITIVITY ANALYSIS: LIMITATIONS?
– ignores co-relations
PROBABILISTIC APPROACHES
RISK ANALYSIS
• MONTE CARLO METHOD
Procedure to establish an expected value of a project
viability indicator based on probabilistic distribution of all
potential project outcomes77
- select a value, at random, for each variable
- determine NPV
- repeat random selection / determination
of NPV
probability distribution of NPV
STEPS OF RISK ANALYSIS
SELECT KEY
VARIABLES
SPECIFY PROBABILITY
DISTRIBUTION
SIMULATE
- disaggregation
- subjective probabilities
- formal method78
NPV
Sb
Sa
PROJECT B
PROJECT A
E
PROBABILITY
PROBABILITY DISTRIBUTION OF NPV79
CUMULATIVE PROBABILITY OF NPV
CUMULATIVE PROBABILITY(%)
-5 0 5 10 15
%
100
80
60
40
25
15
NPV ($Mn)
PROJECT B
PROJECT A80
ECONOMIC EVALUATION: SOME ISSUES
• UNQUANTIFIABLES
• UTILITY – AS A MEASURE OF WELFARE
• DISTRIBUTIVE JUSTICE
• INTER-GENERATIONAL EQUITYPEDIGEE OF COST-BENEFIT ANALYSIS
• Belated union between two separate developments
- practical foundations
- conceptual foundations
• Advent – administrative tool for water resource
management (early 1900s)
81PEDIGREE OF COST-BENEFIT ANALYSIS (contd.)
• Early application
- US Bureau of Reclamation
- Army Corps of Engineers
• US Bureau of Reclamation
- Reclamation Act 1902
- dams/canals for agricultural development
• Army Corps of Engineers
- flood control and navigation
82PEDIGREE OF COST-BENEFIT ANALYSIS (contd.)
• Rivers and Harbours Act 1902
- justification: commercial benefits
• Flood Control Act 1936
- emphasis on social justification
- notion of general welfare
• Spread to other spheres
- user pays
83PEDIGREE OF COST-BENEFIT ANALYSIS (contd.)
• Green Book of 1950 (US Federal Inter-Agency River
Basin Committee)
- rules for comparing costs and benefits
• US Bureau of Budget’s Budget Circular A-47
(1952)
- formalization of the technique
- applications in budget management
• Eckstein, Krutilla, McKean (1958)
- welfare economics foundations (utility)
- water resource development 84THE PEDIGREE OF COST-BENEFIT ANALYSIS (contd.)
• Mass (1962)
- strengthening of welfare-economics base
- water resource
• Late-1950s, Early-1960s
- criticism of welfare-economics base
- practice however flourished – new areas
• Late 1950s – arrival in UK
- motorways
• Late 1960s – developing countries
– UNIDO, WB, ADB, OECD
• Some recent developments 85BIBLIOGRAPHY
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