Project Evaluation and Sustainability

Mette Trier Damgaard

Department of Economics and Business Economics
mdamgaard@econ.au.dk
Outline

Introduction to Project evaluation and sustainability

Introduction to cost-benefit analysis

What Cost-Benefit Analysis (CBA) is about

The basic steps of a CBA
Conceptual foundations of CBA
Limitations of CBA

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A bit about myself
Mette Trier Damgaard

Assistant Professor at the Department of Economics and Business Economics

Background:
PhD in Applied Behavioural Economics from AU
(Senior) Economic Consultant at London Economics
MSc in Economics from AU
BSc in Economics and Management from AU

Contact information:
E-mail: mdamgaard@econ.au.dk
Office: B11

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About the course
Aim of the course
Introduce you to the basic elements of project evaluation (cost-benefit) techniques

Train you in the application of the basic methodologies from welfare economics and
microeconomics in relation to project evaluation

At the end of the course, you should be able to:

Describe, explain, discuss and relate core concepts and methods of project evaluation

Apply and use basic methods in project evaluation

Independently reflect on and analyse topics in relation to project evaluation

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About the course
Project evaluation
Project evaluation methodologies are important to determine whether specific
initiatives develop the economy in a more sustainable direction.

Using examples related to sustainability topics.

Active participation

Prerequisite: knowledge of microeconomics

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Practical information
2 hours per week

Teaching style:
Lecturing
In-class online quizzes
In-class exercises
Case
You select a topic of interest (in groups)
Role-play you are a consultant who is asked to conduct a CBA on the chosen topic
Discussion in last two weeks with the rest of the class

Exam:
3-hours, open-book written exam
Performance on in-class quizzes NOT part of final grade

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The exam
The student is expected to use the theoretical basis of knowledge from the course as well as
demonstrating abilities to perform independent analysis and evaluation, using relevant
theories and methods given in the lectures.

The maximum grade 12 requires a complete and outstanding answer to all questions in the
exam, both with respect to factual knowledge, with respect to project evaluation concepts,
definitions, and theories, etc. and also with respect to proficiency at the combinational and
analytical level. Furthermore to get 12, the answers to the exam questions have to be
coherent and elaborate using all relevant elements from the course, and besides the student
shall demonstrate overview and understanding by only including the necessary and relevant
elements in his/her answers and analysis.

The grade 02 will be characterized by including relevant elements from the course, providing
substantial factual knowledge with respect to basic concepts, definitions, and theories, and
demonstrating the ability to replicate important definitions, concepts and theories, but without
showing significant independent elements of analysis. The answers to the questions should
be without serious flaws or mistakes, irrelevant elements and partly erroneous answers may
occur. Still the student reveals some knowledge going beyond common knowledge on the
topics.

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What is cost-benefit analysis?

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A thought experiment

Imagine that you are a consultant and need to advise in

which project the municipality of Aarhus should invest to
have cleaner water, the different alternatives are:

(1) a program cleaning water through the use of chemicals

(2) a program cleaning water through the use of pumps

what would you consider when making your recommendation?

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The essence of CBA
Unlimited wants VS limited means

Scarcity of resources trade-offs opportunity costs

CBA is an assessment of all costs and all benefits accruing to a society,

following the decision to invest in a given project
Net social benefits (NSB) = social benefits social costs

Is it in the best interest of the public to conduct a project (NSB>0)?

Which project should be chosen (Maximum NSB)?

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Second-best solution
In a perfect world:

all costs and benefits can be valued

no distortion caused by taxes, externalities or market imperfections

welfare analysis is much more simple: only one discount rate, prices are
indicative of social value, etc.

In the real world

CBA not the only basis for decision making!!!

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Different types of CBA
Project length

Ex-ante CBA - Standard CBA Ex-post CBA

Before the project or After the project is

investment started conducted

Whether government should For learning purposes

invest in project X or not
In media res CBA

Conducted after the project

started but before the project
ended

Whether or not to continue

project X
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Basic steps of a CBA
1. Identify the problem and issue of standing
2. Identify the alternatives
3. Set out assumptions
4. Identify impact categories & select measures
5. Quantifying impacts when possible
6. Deal with unquantified impacts
7. Discount costs and benefits
8. Compute Net Present Value (NPV) for each alternative projects
9. Sensitivity analysis
10. Make recommendation

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Conceptual foundations of CBA

Efficiency
Measuring costs and benefits
Willingness to pay
Limitations of CBA

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Measuring efficiency
Pareto optimal/efficient:
No alternative way of allocating
resources can make one more
individual happy without making at
least one individual worse off
Tempting to say that policies should be
adopted only if they are Pareto
optimal/efficient/improving

Is it realistic
think that a project or a
policy will make
nobody worse off?

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Measuring efficiency
Alternative:

potential Pareto efficiency (Kaldor-Hicks criterion):

A project is desirable if the money measure of gains exceeds the money measure of
losses
Those who would gain could fully compensate the losers

Tempting to require that compensation is implemented making the allocation

Pareto efficient.

Very costly one would need to evaluate costs and benefits for each individual
Transaction costs for compensation payments.

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 Project evaluation technique
should lead to improved
efficiency

However, no certainty that efficiency

will be maximized

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KH criterion
Mainstream assumptions:

1. Gains WTP; losses WTA

2. Potential compensation tests
3. Equal and constant marginal utility of income
4. Non-monetary effects included
5. No consideration of moral sentiments
6. No transaction costs

Updated version: KHM

Uses an efficiency test (rather than potential compensation tests)

Excludes values that are illegal or immoral
Includes moral sentiments caring for others/altruism
Includes transaction costs
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Measuring costs and benefits
Mainstream assumptions:

1. Gains WTP; losses WTA

2. Potential compensation tests
3. Equal and constant marginal utility of income
4. Non-monetary effects included
5. No consideration of moral sentiments
6. No transaction costs

Updated version: KHM

Uses an efficiency test (rather than potential compensation tests)

Excludes values that are illegal or immoral
Includes moral sentiments caring for others/altruism
Includes transaction costs
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Measuring costs and benefits

Benefits:
Gains (WTP) : The sum of the maximum willingness to pay (WTP) to obtain the
benefits of the project.
Loss restored (WTA) : The sum of the maximum willingness to accept (WTA)
compensation for losses restored due to the project

Costs:
Losses (WTA) : The sum of the minimum WTA money to avoid the costs of the
project

Gains foregone (WTP) : The sum of the WTP for gains foregone due to the
project

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Measuring costs and benefits

Grounded in the notion of legal rights

WTP used in cases with no legal or psychological ownership i.e. for gains
WTA compensation used in cases with ownership for something i.e. for losses

Measured relative to the status quo

Directs choice of when to use WTA and WTP

In theory: WTP=WTA ..but there is a so called status quo bias

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The status-quo bias
Criticism of the KH criteria

Point of departure matters for conclusion

Persons WTP WTA
to move from A to B to move from A to B
Person 1 100 120
Person 2 -90 -105
Move from A to B 100 105 = -5
Move from B to A 90-120 = -30

Moving from A to B is not beneficial

Moving from B to A is not beneficial

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WTP/WTA
Imperfect measures highly criticised
Market values Does it make sense to put a monetary value on e.g. clean air?
Aggregating WTP may end-up with non-transitive ordering
Preference Person 1 Person 2 Person3 Pairwise voting:
ordering
First choice X Z Y X vs Y X wins
Y vs Z Y wins
Second choice Y X Z X vs Z Z wins

Third choice Z Y X

WTP/WTA and wealth as your wealth increases, would you be more or less
willing to pay for a policy? Leads to distributional concerns

Whose WTP/WTA to include should you include the benefits accruing to

criminals from the adoption of a policy which would favour re-integration of
criminals into the society? 25
Potential compensation vs. efficiency
Mainstream assumptions:

1. Gains WTP; losses WTA

2. Potential compensation tests
3. Equal and constant marginal utility of income
4. Non-monetary effects included
5. No consideration of moral sentiments
6. No transaction costs

Updated version: KHM

Uses an efficiency test (rather than potential compensation tests)

Excludes values that are illegal or immoral
Includes moral sentiments caring for others/altruism
Includes transaction costs
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Efficiency measures
CBA efficiency measures are tests of potential Pareto efficiency

Potential compensation tests (PCT)

Builds on idea of possible compensation

KH criterion
Losing parties WTA compensation < Winning parties WTP

Scitovsky criterion
Losing parties WTP to avoid project < Winning parties WTA

Efficiency test using net social benefits

NSB > 0 or max(NSB)

> 0 : possible to find a way in which at least one person

is better off while no one is worse off, through side payments
> 0 : Pareto improving
We will use NSB and
refer to it as KH!! 27
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In-class quiz

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Including moral sentiments
Mainstream assumptions:

1. Gains WTP; losses WTA

2. Potential compensation tests
3. Equal and constant marginal utility of income
4. Non-monetary effects included
5. No consideration of moral sentiments
6. No transaction costs

Updated version: KHM

Uses an efficiency test (rather than potential compensation tests)

Excludes values that are illegal or immoral
Includes moral sentiments caring for others/altruism
Includes transaction costs
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Including moral sentiments
Moral sentiment is concern for others

In economics sometimes referred to as social preferences

Example: program cleaning water financed through payroll taxes

Group 1 is disadvantaged group with no work. They have no other water
source no costs but large benefits
Group 2 have work, a different water source, and likes to know that
Group 1 has access to clean water large costs and small direct
benefits
Benefits Costs Benefit-Costs
Group 1 100 0 u1=100
Group 2 40+1.5u1=190 160 u2=30
NSB 130
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Including moral sentiments
Critiques

Possible acceptance of projects that fail to pass PCT

not if people in aggregate are sufficiently altruistic
excluding moral sentiments may also read to wrong conclusions

Different weights assigned to different people

The utility of everyone is weighted in the same way but

Potential for inclusion of bad sentiments

addressed by the concept of standing which excludes values that are illegal or immoral

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CBA: some limitations
Technical limitations cannot value all benefits (and/or costs)
Qualitative CBA
How big unmeasurable impacts need to be to reverse the recommendation

Distributional aspects CBA ignores them

Distributionally weighted CBA but how to set the weights?!

Moral concerns how to deal with undesirable behaviors and socially

unacceptable preferences?
Laws (legal rights) may help in distinguishing between values having standing or not

Other goals efficiency may not be the only objective!!!!

Compare all alternatives in terms of all relevant goals trade-off between goals

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Wrap-up

What can CBA be used for?

The basic principles behind

NSB
WTP vs WTA

It is not perfect highly criticized method

Distribution
What about unquantifiable or non-valuable impacts?
Should we only focus on efficiency?
Technical limitations
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Next time
Standing in CBA

Whose costs and benefits should be included?

The notion of transfers
Distributional issues
Future generations

The notion of welfare

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