Lecture 5

Economic evaluation of projects

DDIT DIRE DAWA INSITUTE OF TECHNOLOGY

 Introduction
The financial evaluation of a project studies its performance and

return (profitability) from the points of view of the industry (the

utility and the firm), the owner and the investor.

Economic evaluation, on the other hand, studies project benefits

and returns from the national economy point of view and assesses

the effect the project will have on the overall economy of the

country.

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 Introduction
While small projects have limited, if any, impact on the national

economy, large projects have social and environmental effects.

A modern construction projects normally costs hundreds of millions

of pounds, and so do some network projects.

In high-capital projects of this nature it is necessary to find the

least-cost solution not only from the point of view of the industry

but from that of the national economy as well.

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 Introduction
The project evaluation should not be restricted to its profitability

and should also evaluate its national economic and environmental

impacts (social impacts) and compare them with those of other

competing projects in the resource-limited national economy to

ensure economic efficiency.

Economical analysis of major projects, therefore, evaluates two

things: (1) the priority of the project in the national plans of the

country and (2) its effect on the overall economy of the country.
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 Introduction
Economic efficiency is important to society and has four primary

components.

The first component is the requirement of production efficiency, or

incurring the minimum feasible cost in producing goods and

services sold.

Second, efficient variety is needed, meaning that the menu of goods

and services offered is tailored to the wants and needs of customers.

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 Introduction
Third, society wants allocative efficiency, where the goods and

services go to customers who value these goods and services most

highly.

Finally, society wants dynamic efficiency, which means that the

first three types of efficiency are sustained.

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 Introduction
Economic efficiency (social and environmental costs and benefits)

should be a fundamental criterion of public investment and policy

making.

It should also be fundamental for large capital-intensive private

sector investment that replaces, supplements or competes with

public investment.
If real costs and benefits of large projects are not addressed from
the perspectives both of the industry and of the whole economy the
wrong projects (or alternatives) may be selected.
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 Introduction
The same method of discounting costs and benefits is used for both

financial and economic evaluation.

Economic evaluation is concerned with estimating the economic

rate of return (ERR).

Financial analysis, on the other hand, evaluates the internal rate of

return (IRR) and considers only financial parameters in the

analysis.

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 Introduction
A project, for example building a power station firing cheap low-

quality coal and located near the load centre, may have a high

financial IRR.

But when environmental costs of the project are considered they

may result in low (or negative) ERR and may lead to the rejection

of the project on economic rather than financial grounds.

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 Introduction
In many cases market prices do not reflect the real cost of

resources, products or services to the economy.

Market prices are usually distorted by duties, taxes, subsidies and

other trade restrictions.

Such instruments have a major influence on the financial

profitability of a project from the industry or investor’s point of

view but none on its economic viability from the perspective of the

national economy.
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 Introduction
Distortions, particularly subsidies, vary from one country to another

but are more prominent in the developing countries than in market

economies where efficient and transparent prices prevail.

This is most vividly exemplified in the construction industry where

in most countries prices of fuels are set at a level far from their true

cost to the economy.

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From financial evaluation to economic evaluation
The two time streams of financial costs and benefits form the

starting point for economic evaluation.

These financial streams have to be adjusted and modified with

regard to the concepts of transfer payments, border and shadow

pricing, and externalities.

The essence of sound economic evaluation is to remove distortions,

particularly price distortions, to improve investment decisions.

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From financial evaluation to economic evaluation
Such distortions are mainly caused by transfer payments (subsidies,

taxes and levies), imperfections in the domestic market

(monopolies, restrictive practices, etc.) and distortions caused by

trade policies (exchange rates, quotas, etc.).

To shift from financial to economic evaluation it is essential to

implement a number of steps:

(a) remove direct transfer payments,

(b) use border prices in the case of traded goods and services

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From financial evaluation to economic evaluation
(c) use shadow prices, particularly in dealing with non-traded items

(such as land, unskilled labour, etc.),

(d) account for externalities (especially environmental impacts and

costs), and (e) allow for the difference between accounting and the

official price of foreign exchange, if any.

Therefore, in economic evaluation, transfer payments (taxes, duties,
subsidies) are not included.
Costs and benefits are priced in border (international) prices for
traded goods and shadow prices for non-traded goods.
Externalities, whenever they exist, are added to costs and benefits.
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 Transfer payments
A transfer payment is a payment made without receiving any good

or direct service in return.

In economic evaluation of projects the most-encountered transfer

payments are taxes and direct subsidies, as well as loans and debt

service (payment of interest and repayment of principal).

These are treated as transfer payments because the loan terms only
divide the claims to goods and services between borrowers and
lenders and do not affect the total amount of true return to
investment.
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 Transfer payments
Transfer payments represent only shifts in claims to goods and

services and not use of new production.

They do not increase or reduce national income and are hence

omitted when converting financial streams used in financial

evaluation to economic values used in economic evaluation.

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 Transfer payments
Economic analysis is not concerned with sources of investment

funds (equity or loans or a combination of these) and repayment of

loans (particularly local loans), since similarly the loan and its

repayment are financial transfers and are not part of the economic

analysis.

The economic cost of a project is its investment cost in the base

year less its discounted terminal value if any.

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 Transfer payments
It is, however, essential to distinguish between taxes that are

transfer payments and are ignored in economic analysis, and other

taxes that are a payment for goods and services and should be

included.

For instance, a road tax can be a payment for the services provided

by the road, and a municipality tax can involve a charge for

sewerage and should therefore be included in the analysis.

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 Externalities
An externality is an effect of a project felt outside its confines and

is not included in its financial evaluation.

Externalities may be either technological or monetary.

An example of a technological externality might be pollution from

a power station that causes direct material and health damage.
Economic evaluation usually tries to incorporate technological
externalities, especially costs, within the project account and thus
change them from externalities to project costs and benefits
(internalise them).
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 Externalities
For example, costs of the damage to buildings and health by
sulphur dioxide (SO2) emissions, and to water basins caused by the
waste discharges from the power station, may be calculated and
assigned to the project.

Monetary externalities arise when the project affects the prices paid
or received by others outside the project, for example, where
building a new efficient and clean power station reduces prices of
electricity to users.

Monetary externalities have to be included in both project financial

and economic analysis.
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 Externalities
It is important to try to identify all externalities caused by the
project.

Where there are significant externalities an attempt should be made

to quantify them and include their values in the project costs and

benefits.

Where it is difficult to quantify them, as usually is the case, they

should be cited in the project economical evaluation and they may

affect the choice of the least-cost solution.

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 Border and shadow pricing
Border prices are world prices; and during construction each project
incorporates a lot of inputs (resources) such as equipment,
materials, land and manpower.

During the lifetime of the project it also consumes inputs, and

produces output (product).

Among the most important operational inputs in power projects are

fuel, manpower and similar resources.

In the financial evaluation these inputs are valued at their market
prices.
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 Border and shadow pricing
Market prices are almost never ideal and are often distorted to
varying degrees in different countries.

The industry and investors are mainly interested in market prices of

inputs and outputs because that is what they have to deal with and it

is these prices that determine financial profitability.

Economic evaluation goes beyond this by investigating the true

impact of the project on the national welfare.

To achieve this, prices of resources must be set at their true cost to

the economy.
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 Border and shadow pricing
Inputs and outputs can be classified into two categories: traded and

non-traded.

A project input or output is deemed to be traded if its production or

consumption will affect a country’s level of imports or exports at

the margin.

A project input or output is considered to be non-traded because of

its bulkiness, cost consideration and immobility or other restrictive
trade practices.

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 Border and shadow pricing
Machinery and equipment, as well as fuel and skilled labour and

marketable products, are considered tradable.

Non-traded goods and services include items like land, water,

buildings, unskilled labour, electricity (in most cases) and many

other services and bulky material.

Traded and non-traded goods and services are part of project inputs
and outputs.
Non-tradable inputs (gravel, sand, stones, labour, etc.) have to be
shadow priced through utilising conversion factors.
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 Pricing traded inputs and outputs
Because they can be traded, i.e. imported as well as exported,

tradable inputs and outputs create a change in the country’s net

import or net export position at the margin.

They must be valued, in economic evaluation, at border prices.

Border prices are world prices, free on board (FOB) for exports and
cost, insurance and freight/cargo (CIF) landed cost for imports,
adjusted by allowing for domestic transfer costs.

Transfer costs are costs that are incurred in moving inputs and
outputs between project site, border and target markets.
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 Pricing traded inputs and outputs
Take coal as an example.

The border price of imported coal, which will be incorporated in the

economic evaluation, will be the CIF price at the nearest port plus

handling and transport charges to the generating plant.

If this coal is produced locally, its economic price will be its FOB

price at the port of export minus the cost of transport from the

coalmine to the port plus the cost of transport to the generating

plant.
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 Pricing traded inputs and outputs
Consider an example in which coal can be imported by country ‘y’
at $80 ton−1 with transport cost between country ‘x’ and country ‘y’
at $20 ton−1.
If country ‘x’ would export its production to country ‘y’ then it has
to price it at $60 ton−1 ($80 − $20 ton−1).

If the cost of handling this coal and transporting it to the export port
of country ‘x’ is $15 ton−1, then coal at the mine-mouth has to be
$45 ton−1.
If this coal will be used locally instead and with transport plus
handling cost of $5 ton−1 from the local mine to the local power
station then the economic cost of coal, will be $45 + $5, i.e. $50
ton−1, irrespective of the actual cost of extraction, which can be
much less.
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 Pricing traded inputs and outputs
If the cost of production of coal in country ‘x’ increases and it

considers importing outside coal from a source with a sea transport

cost of $15 ton−1, then its cost CIF of imported coal will be $50 +

$15 = $65 ton−1.

If transport of this coal to the power station will involve another $8

ton−1 then the total cost of imported coal to the power station will be

$73 ton−1.

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 Pricing traded inputs and outputs
Country ‘x’ is advised to continue production of coal as long as its
production cost is equal to $68 ($73 − $5 ton−1 local transport cost
from mine to power station).

If country ‘x’ decides to continue producing coal from its mines,

even if its production cost reaches $90 ton−1, while selling it at $70
ton−1 to the power station, then its coal subsidies will amount to $20
ton−1.

Such subsidies are excluded in the economic evaluation.

The market price for coal will be $70 ton−1 in the financial
evaluation of the investors, and $73 ton−1 (i.e. the border price) in
the case of economic evaluation.
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 Pricing traded inputs and outputs
A decision to utilise a local resource (like coal) is not dependent

only on production costs and border prices but is also influenced by

many other political and social considerations, like utilising local

resources, creating local employment, supply security and shortage

of foreign exchange.

In making such decisions, however, the border price of coal has to

be calculated and taken into consideration in evaluating plans and

decisions.
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 Pricing non-traded inputs and services
In evaluating non-traded goods and services it is essential to

differentiate between non-traded tradables and non-tradables.

Non-traded tradables are goods and services that can be traded on

the international market but are not because of their cost being

higher than international prices (e.g. local low quality coal), or

because of trade restrictions and policies (quotas, restrictive import

taxes at potential import markets, etc.)

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 Pricing non-traded inputs and services
A good example of a non-traded tradable is coal. If the international

price of coal is $50 and its transport to the power station involves

an additional $23, a local coalmine with a high production cost of

$68 (which is above international prices hence rendering its product

a non-traded tradable) will continue production protected by the

high transport prices.

In such cases the economic price of a non-traded tradable
commodity is the opportunity cost of the product, that is the price it
can command in the absence of the project.
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 Pricing non-traded inputs and services
Most power projects involve non-tradable inputs, mainly materials

for civil works and labour.

Such inputs can be decomposed into its components.

Large civil works like a power station building contain tradable and

non-tradable components.

Tradable inputs (cement, steel, etc.) can be priced in accordance

with their border prices.
Non-tradable inputs (gravel, sand, stones, labour, etc.) have to be
shadow priced through utilising conversion factors.
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 Pricing non-traded inputs and services
The most widely used factor is the standard conversion factor
(SCF).

This factor is the average ratio of border and domestic market

prices and is equal to

where M = CIF value of imports, X = FOB price for exports, Tm =

all taxes on imports, Tx = all taxes on exports.

Through applying this conversion factor by multiplying it by the

non-tradable inputs it is possible to reduce the impact of local
distortions.
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 Pricing non-traded inputs and services
In a way the SCF is the ratio between an official and a shadow
exchange rate. In developing countries it is usually less than unity,
signifying that the local currency is overvalued.

Consider a country with imports valued at 100 million currency

units and exports of 50 million units, import taxes of 20 million
units and export taxes of zero.

The SCF is equal to 0.88 (which is (100 + 50) million divided by

[(100 + 20) + (50 − 0)] million).

It is also usual to have a SCF equal to 1.0 for skilled labour and 0.5
for unskilled labour.
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Thank you !!!

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