Economic and Social Cost Benefit Analysis Dr.

Tarun Das, Professor (Public Policy), IILM, New Delhi-110003, India. EMAIL: tarun.das@iilm.edu/ das.tarun@hotmail.com
1. Introduction The starting point of a pre-project evaluation is to make a technical feasibility study by the engineers and other technical experts to examine whether the project is technically sound. The technical team then specifies the technical details for the project for its project specification, implementation and maintenance over time. After examining the technical feasibility of a project, it needs to be examined whether the project is financially viable, economically sustainable and socially (or environmentally) desirable. Accordingly, there are four basic techniques for the pre-evaluation of a project and a Detailed Project Report (DPR) by any lead investment bank must include the following methods depending on the purpose of the project, the methods for project financing, policies for recovering of costs and fixing of charges from the users: (a) (b) (c) (d) Technical feasibility analysis; Financial cost-benefit analysis; Economic cost-benefit analysis and Social (or environmental) cost-benefit analysis.

This paper focuses on the financial, economic and social cost-benefit appraisal techniques. Financial cost-benefit analysis The traditional financial cost-benefit analysis deals with actual financial transactions and makes orthodox commercial analysis on the basis of market prices of products and all factors of production. It does not deal with the questions of distributional equity and does not make an analysis of the impact of externalities. The financial analysis generally estimates the cost/ benefit ratio (CBR), net present value of benefits (NPV) and the Internal Rate of Return (IRR). Financial viability conditions require that CBR<1, NPV>0, IRR>PLR where PLR is the prime lending rate charged by the funding agencies. Year 1 2 3 … a Total Cost C1 C2 C3 … Ca ∑Ca Table 1.1: Project Evaluation Criteria: Benefit Present value of cost Present value of benefit B1 B2 B3 … Ba ∑Ba C1/(1+r)¹ C2/(1+r)² C3/(1+r)³ … Ca/(1+r)ª ∑Ca /(1+r)ª B1/(1+r)¹ B2/(1+r)² B3/(1+r)³ … Ba/(1+r)ª ∑Ba /(1+r)ª

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1. Benefit/Cost Ratio (BCR) = ∑Ba /(1+r)ª / ∑Ca /(1+r)ª 2. NPV = ∑Ba /(1+r)ª - ∑Ca /(1+r)ª 3. Internal Rate of Return (IRR) is the value of r at which the PV of benefits equals the PV of Costs or NPV = 0 i.e. ∑Ba /(1+r)ª = ∑Ca /(1+r)ª Economic cost-benefit analysis In the economic cost-benefit analysis, instead of market prices, the appraisal is based on the economic costs or the resource costs or opportunity costs of both of the factors of production and the outputs. This is done on the basis of the following two adjustments in the financial cost-benefit analysis: (i) All costs are netted out of all indirect taxes and duties and subsidies. (ii) The scarce and surplus factors are shadow priced. In general, one attaches shadow prices to labour, energy and foreign exchange cost to take care of their either scarcity values or slack values. Shadow prices for scarce items (i.e. items with excess demand such as energy, foreign exchange and skilled labor) will have shadow prices higher than their market prices, whereas items with excess supply (for example unskilled labour) will have shadow prices lower than their market prices. (iii) Some examples of shadow prices in India: (1) Border prices for tradable items (fob price for exportable items and CIF price for importable items) (2) 0.80 for unskilled and 1.20 for skilled labor (3) Black-market rate (1.05) for foreign exchange (4) 1.20 for energy and non-renewable natural resources Social cost-benefit analysis. Social cost benefit analysis goes further beyond the financial and economic cost-benefit analysis, and deals with not only efficiency pricing but also takes care of distributional equity and impact of externalities on the project. The two most prominent methodologies, which address these issues in a systematic way, are the UNIDO (1972) and Little Mirrelees (1968, 1974) book on projects appraisal. Continual discussions and debates on these two approaches have led to a vast literature on refinements and synthesis of techniques, and more sophistication in comparison with the conventional commercial profitability analysis. Table 1.2 below summarizes the basic differences in these three types of cost-benefit analysis and Annex-1 provides a numerical example for a road construction project. It may be particularly noted that the impact of externalities and indirect costs and benefits are not considered under financial and economic cost-benefit analysis, but are considered for social cost benefit analysis. Major social and environmental costs include costs for

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pollution control, public health, safety, security, environmental degradation (soil erosion, deforestation), costs for rehabilitation, retraining etc. Major social and environmental benefits include reduction of poverty through income rise, rise in longevity, increase of prices of land, houses, crops etc. For example, for a road construction project, external costs may include costs due to pollution, accidents, traffic police, street lighting, rehabilitation of displaced people, cost of deforestation, if any, etc.; whereas external benefits will include rise of income, property and commodity prices in the hinterland area due to better mobility of workers and enhanced accessibility of agricultural lands and adjacent regions to the commodity markets and urban areas. Table 1.2 Differences in Financial, Economic and Social cost-benefit appraisal Items 1. Project costs Financial Economic Social

Actual financial costs Some items are shadow Some items are shadow priced priced 2. Project benefits Actual financial Some items are shadow Some items are shadow benefits priced priced 3. Indirect taxes, Are taken into account Are excluded Are excluded duties, subsidies 4. Shadow prices Not used Used Used 5. Externalities Not considered Not considered Considered Criteria Table 1.3: Criteria for Acceptance of Project Financial Economic BCR >1 NPV > 0 Social BCR >1 NPV > 0

1. Benefit/ cost BCR >1 ratio (BCR) 2. Net Present NPV > 0 Value (NPV) 3. Internal Rate of Financial IRR > PLR Return (IRR) (Prime lending rate)

Economic IRR > 6 Social IRR > 12 (Real rate of interest or (Social rate of real GDP growth) discounting)

2. Project Appraisal Techniques Given limited public resources and competing sectors needing public funds, it is necessary to make a comprehensive analysis of social costs and social benefits of a project and to bring its coherence to the list of investment projects. What is needed for that is a technique that would rank projects in order of their economic desirability, so that they could be adopted in rank order until the investment budget is exhausted. Previously, development economists had argued the merits of different criteria for deciding on project investment - the degree of capital intensity, the rate of reinvestment, 3

the internal rate of return, the cost/benefit ratio, the size of the externalities and so on. The integration of these various investment criteria within a single procedure of appraisal of net present value was the work of Little and Mirrlees. A major issue of project appraisal is to measure the true cost of transferring a marginal unit of rural labour to urban employment, rather than assuming (as Lewis did) that the transfer is costless. At the same time, the valuation of a project’s non-labour inputs and outputs also pose difficult problems. They are due to the interventions by the governments that affect price formation in both rural and urban areas. For example, procurement of foodgrains at minimum support prices by the government of India pushes up market prices, while supply of subsidized foodgrains through ration shops of fair price shops puts downward pressure on market prices. Constraints of social cost-benefit appraisal Determination of market price is a complex issue. In any case, they are deviations from the market-clearing prices in a perfectly competitive market, as the real markets are neither perfect nor competitive. These deviations are referred to as price distortions due to market imperfections, but the idea of a price distortion makes sense only relative to some standard of undistorted prices. Little and Mirrlees proposed ‘world prices’ as their ‘sheet anchor’, but there are skepticisms among the economists, as there is no single “world price”. However, the use of world prices as a norm makes a significant shift in economic thinking about development. Moreover, there is a more fundamental problem. The SCBA technique is an attempt to use ‘shadow’ prices to select investments, that is, to invest as if free market prices ruled, when in fact they do not. If the market ruling prices are not based on the principles of shadow pricing, then the outcome will not be realized. It is well known that perfect competitions is a utopia and does not exist in reality. As mentioned earlier, the real markets are neither competitive nor perfect. Investments chosen on the basis of economic costs or resource cost would not necessarily be financially viable unless the existing prices are determined by the economic costs. This implis that the survival of the projects would depend either on the government’s continuing ability to give them subsidies, a condition that becomes more difficult as the politico-economic turbulence has unfolded recently in many parts of the world. The alternative and the recommended option for the government is to dismantle the interventions that prevent projects from being profitable and to make suitable public policies that attract private investment including foreign investment for project funding on the basis of market determined and rational prices for inputs and outputs.. To give an example, in the middle of 1980s, the present author built a multi-regional multi-sectoral multi-modal transport-planning model for the Planning Commission of India on the basis of economic costs where labor, foreign exchange and energy costs were shadow-priced. Financial wage costs for unskilled labor were reduced by 20 percent, while energy costs were enhanced by 20 percent and foreign exchange costs were enhanced by 25 percent (i.e. shadow price of labour was taken as 0.8, and shadow

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price of energy as 1.2 and shadow price of foreign exchange as 1.25). Then the economic cost was estimated for both rail and road by adding operator’s costs and user cost’s. On the basis of economic cost, road transport cost was observed to be lower than the rail transport cost for short distance, while rail transport had comparative advantage for long distance. The distance at which road looses its comparative advantage for transport of goods and passengers is called “break even point”. Figure-2.1: An Example of Break-Even Point Between Rail and Road-

Table-2.1: Break Even Points for Roads (kilometers) Goods Road Average BE Point (KM) BE Point (KM) % shift of Lead (kms) 1976-77 price 1986-87 price BE Point Food-grains 386 247 280 +13.4 Coal 469 201 232 +15.4 Iron ore 373 241 324 +34.4 POL 271 60 67 +10.1 Iron-steel 487 311 220 -29.3 Cement 276 222 193 -13.1 Fertilizers 292 200 184 -8.0 All goods 406 200 210 +5.0 Note: Break-even point is the distance at which road looses its comparative advantage in terms of unit transport cost for the movement of specific commodities.

nsport Cost (Rs)

400 300 200 100 0

The transport model calibrated on the basis of economic costs of transportation for rail and road led to the following conclusions: 1. Rail transport is least expensive for long and medium distance and bulk traffic.

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2. Rail transport is least energy intensive, more environment friendly and less accident prone than road transport. 3. Road transport is the cheapest mode for short distance and consumer friendly for door to door service. It also generates more employment and helps in enhancing rural connectivity and reducing poverty. 4. However, road transport is more energy intensive and leads to pollution problems and traffic hazards. On the basis of economic costs for transporting goods and passengers, modal shares for rail and road were projected for future, and required capacity expansions and transport investments were estimated by the model. It was recommended that rail should have a share of 75 percent in total goods and passenger traffic. However, due to political economy constraints, rail passenger fares and freight rates for goods traffic were kept low as compared their economic costs, and the projected rail corridors were not expanded or upgraded. As a result, over the years, actual modal shares became completely reverse resulting in irrational and non-optimal modal shares. Presently, roads account for 75 percent traffic for both passengers and freight and rails account for only 25 percent of traffic resulting in huge loss of economic resources. 3. Identification of Benefits and Costs In social cost benefit analysis, the most important and the most difficult task is to identify and measure all social costs and benefits associated with the projects. These costs and benefits arise due to externalities of the project. They relate to local resources, ecosystem and overall environment. While the technical feasibility and the financial viability excercises are well developed and there are conventional methods to conduct those studies, economic and social cost-benefit analysis depend on the purpose of the studies. The social cost benefit appraisal procedure for projects is very complex, even with short cuts. Moreover, no procedure can preclude opportunities for manipulating the numbers to give the result that political masters would like to have on non-economic considerations. In practice, the social cost-benefit appraisal techniques are scarcely more successful that the financial cost benefit analysis or economic appraisal of projects. Let me discuss these problems in relation to two project reports submitted to the Ministry of Rural Development, which I had a chance to look at. 4. Evaluation of Poverty Alleviation Programs Growth with social justice and alleviation of poverty have been primary objectives of Indian planning since its inception in 1951. Several anti-poverty programs have been in operation for decades focussing the poor as the target groups. These include programs for the welfare of weaker sections, women and children, and a number of special employment programs for self- and wage employment in rural and urban areas. The

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ongoing economic reforms since 1991 have also a human face and attached high priority to the development of social sectors. The government has relied mainly on two approaches for poverty alleviation: the first based on the anticipation that economic growth will have a “trickle down effect” on the levels of living of all groups in society; and the second that direct anti-poverty programs are also required. More recently, government shifted public expenditure away from investment in infrastructure and industry towards social sectors, and improved targeting of subsidies through changes in the public distribution system. Anti-poverty programs have been strengthened over the years to generate more employment, create productive assets, impart technical and entrepreneurial skills and raise the income level of the poor. But most evaluations - whether done by the government or others - agree that these programs have not been very effective in reducing poverty, as these suffer from ill-defined multiple objectives, limited targeting towards the poor, under-funding and often complex administration, high administrative costs and leakage, lack of proper accountability and adequate monitoring. For example, a recent study of the Public Distribution System (PDS) suggested that as little as 25 per cent of the foodgrains actually reach the poorest 40 per cent of the population and that administrative costs far outweigh the income gains to the poor. In general, it costs the government between 2 and 7 rupees (with the highest value reported for the PDS) to provide one rupee to the poor. One of the better-targeted programs is the Integrated Child Development Services (ICDS). Similarly, public works have been relatively more successful at targeting the poor and have improved significantly the living standards of a large number of poor at a relatively low cost.

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Annex-1 A Numerical Example for Financial, Economic and Social Cost Benefit Analysis Of a Road Construction Project connecting hinterland to a sea port (In millions of Indian Rupees) Costs per year A. Project cost Rupee cost -- Basic price -- Excise duty Foreign exchange -- Basic price -- Import duty Total project cost B. Operating cost Skilled labor Unskilled labor Energy Foreign exchange Indirect taxes Less Subsidies Others Total operating cost C. Social costs D. Benefits -- Domestic sales -- Exports Export duty Social benefits Total benefits Financial 504 450 54 220 200 20 724 60 200 100 70 200 (-) 40 410 1000 0 900 300 (-) 50 0 1150 Economic 450 450 0 210 210 0 660 72 160 120 73.5 0 0 410 835.5 0 900 315 0 0 1215 Social 450 450 0 210 210 0 660 72 160 120 73.5 0 0 410 835.5 150 900 315 0 500 1715

Additional Social Benefits and Costs due to externalities E. Indirect cost Policing Environment Basic health Total F. Indirect benefits Rise of individuals income Rise of land and housing prices Rise of crop price Total

50 50 50 150 150 150 200 500

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Financial Cost-Benefit Analysis Year Benefits Costs 1 504 2 220 3 1150 1000 4 1150 1000 5 1150 1000 6 1150 1000 7 1150 1000 8 1150 1000 Total BCR = 0.98

r= Dis.Bnft 0 0 864.0 785.5 714.1 649.1 590.1 536.5 4139.3 NPV =

10 Dis.Cst 458.2 181.8 751.3 683.0 620.9 564.5 513.2 466.5 4239.4 -100.1

Financial Cost-Benefit Analysis r= Year Benefits Costs Dis.Bnft 1 504 0 2 220 0 3 1150 1000 981.7 4 1150 1000 931.3 5 1150 1000 883.5 6 1150 1000 838.1 7 1150 1000 795.0 8 1150 1000 754.2 Total 5183.8 IRR = 5.415 NPV =

5.415 Dis.Cst 478.1 198.0 853.7 809.8 768.2 728.8 691.3 655.8 5183.7 0.1

Financial IRR equals 5.415, NPV is negative and BCR (Benefit/Cost Ratio) is less than unity. So the project is not financially viable, unless the government provides financial support to the project.

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Economic C ost-Benefit Analysis Year Benefits Costs 1 450 2 210 3 1215 835.5 4 1215 835.5 5 1215 835.5 6 1215 835.5 7 1215 835.5 8 1215 835.5 T otal BC = R 1.22

r= Dis.Bnft 0 0 912.8 829.9 754.4 685.8 623.5 566.8 4373.3 NPV =

10 D st is.C 409.1 173.6 627.7 570.7 518.8 471.6 428.7 389.8 3589.9 783.3

Econom C ic ost-Benefit Analysis Year Benefits C osts 1 450 2 210 3 1215 835.5 4 1215 835.5 5 1215 835.5 6 1215 835.5 7 1215 835.5 8 1215 835.5 T otal IR = R 39.13

r= D is.Bnft 0 0 451.1 324.3 233.1 167.5 120.4 86.5 1382.9 N = PV

39.13 D st is.C 323.4 108.5 310.2 223.0 160.3 115.2 82.8 59.5 1382.9 0.0

Economic IRR turns out to be very high at 39.13, BCR=1.22 and NPV=783. So the project is economically viable. Govt can provide financial support and can recover the funds through suitable taxation and pricing policies.

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S c l Cs e e A a s o ia o t-B n fit n ly is Ya er B n fits ee 1 2 3 11 75 4 11 75 5 11 75 6 11 75 7 11 75 8 11 75 T ta ol B R= C 1 .5
h Social

Cs o ts 40 5 20 1 95 8 .5 95 8 .5 95 8 .5 95 8 .5 95 8 .5 95 8 .5

r= D .B ft is n 0 0 1 8 .5 28 1 7 .4 11 1 6 .9 04 98 6 .1 80 8 .1 80 0 .1 6 7 .0 13 N V= P

1 0 D .C t is s 49 0 .1 13 7 .6 70 4 .4 63 7 .1 61 1 .9 56 5 .3 55 0 .7 49 5 .7 4 2 .8 19 2 4 .1 03

Cost-Benefit Analysis Year Benefits Costs 1 450 2 210 3 1715 985.5 4 1715 985.5 5 1715 985.5 6 1715 985.5 7 1715 985.5 8 1715 985.5 Total IRR = 46.31

r= Dis.Bnft 0 0 547.6 374.3 255.8 174.8 119.5 81.7 1553.6 NPV =

46.31 Dis.Cst 323.4 108.5 365.9 263.0 189.0 135.9 97.7 70.2 1553.6 0.0

Social rate of return is also substantially high at 46.31%. So the government can provide financial support and can recover the funds through imposing additional taxes on the beneficiaries of the road project, as well as by imposing “filth tax or pollution tax” on the road users.

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