Cost-Benefit Analysis for Development

A Practical Guide

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• Publisher: Asian Development Bank
• Year: 2013
• Print ISBN: 9789290929574
• eBook ISBN: 9789290929581
• Edition: 1
• Topic: Business
• Subtopic: Operations
• Index: Business

The Asian Development Bank (ADB) has been continuously undertaking measures to enhance the effectiveness of its operations. To improve projects both at the preparation and implementation stages, ADB issued the Guidelines for Economic Analysis of Projects in 1997 as a means to enhancing project quality at entry. The conduct of proper economic analysis helps ensure the efficient use of development funds and public resources and thereby increase aid effectiveness. This practical guide is a supplement to the Guidelines for the Economic Analysis of Projects. It provides an overview of recent methodological developments in cost-benefit analysis as well as suggested improvements in the economic analysis of projects in selected sectors through case studies. These case studies illustrate the application of suggested methodologies, taking into account sector-specific needs, as well as difficulties faced by practitioners in terms of data and time constraints during project processing. It also aims to contribute to ADB's capacity building initiatives as this will be the main reference material for conduct of economic analysis.

1. Introduction

1.1 Rationale

The Asian Development Bank (ADB)’s Guidelines for the Economic Analysis of Projects, issued in 1997, aims to enhance project quality at entry. Promoting rigorous economic analysis helps ensure that ADB finances projects and programs that are not only economically viable, but also represent the most efficient use of scarce resources. As such, rigorous economic analysis contributes significantly to enhanced operational quality and portfolio performance—one of the indicators of operational effectiveness under ADB’s results framework to manage the implementation of Strategy 2020¹—as well as to further development effectiveness.

The guidelines issued in 1997 outline the economic principles underpinning the suggested methodologies for project economic analysis in ADB and provide illustrations of their application. They are supplemented by sector-specific guidelines, technical notes, and other reference materials produced by the Economics and Research Department (ERD) to assist project economic analysis in ADB (see Appendix to this Chapter).

Through a series of annual retrospectives from 2003 to 2008, ERD reviewed the quality of economic analysis in ADB and noted significant scope for improvement, particularly in the articulation of the projects’ economic rationale, demand analysis, and alternatives analysis. The 2007 retrospective indicates significant variations in the quality of project economic analysis across sectors.² On average, energy projects show relatively better quality in their economic analyses, followed by transport, water supply and sanitation, while agriculture and natural resources projects have the greatest need for improvement.

This book, Cost-Benefit Analysis for Development: A Practical Guide, is written in response to the retrospectives’ findings with an aim to supporting ADB’s strategic priorities. This book includes extensive and detailed case studies focusing on infrastructure, comprising integrated urban services (including water supply and sanitation), transport, power generation and transmission. These case studies present economic analyses of relatively better quality than those done in other sectors, although there is still room for improvement. By further enhancing the quality of infrastructure projects—one of ADB’s five core areas of operation—this guide directly contributes to the implementation of Strategy 2020.³

1.2 Organization of this Book

Subsequent to this introductory chapter, the evolution of cost-benefit analysis together with its current use is discussed in Chapter 2. Changing economic policy environments inevitably influence the methodology and practice in cost-benefit analysis. In this chapter, some of the recent methodological developments will be highlighted as they address weaknesses of the original methodology. The chapter also reviews the current practice of cost-benefit analysis by international donor agencies or national governments to establish the relevance of cost-benefit analysis in contemporary development efforts.

Chapter 3 discusses the theoretical foundations for the choice of the social discount rate (SDR), which is critical in project economic analysis. It provides a survey of the vast literature on the SDR, covering theory, estimation methods, and policy practices. The survey reveals significant variations in public discount rate policies, with developing countries in general applying higher SDR rates (8%–15%) than developed countries (3%–7%). While these variations reflect the different analytical approaches used, the divergence more importantly reflects the differences in the perceived social opportunity cost of public funds across countries, and in the extent to which intergenerational equity is taken into consideration in setting the SDR.

The remainder of the book is devoted to sector-specific guidelines, examples, and case studies. Each case study covers the entire spectrum of the analysis—macroeconomic and sector context, economic rationale, demand, alternatives/least-cost, cost-benefit, sensitivity, risk, and distribution. Meant for illustration purposes, the depth of the presentation varies across sectors to highlight particular aspects of the analysis where minor improvements can be effected to enhance the quality of the economic analysis.

Chapter 4 outlines good practices in conducting willingness-to-pay (WTP) surveys in the water supply and sanitation sector (WSS). Reliable estimates of WTP constitute the basis for assessing effective demand and the benefits of WSS service improvements. The chapter argues that oftentimes, WTP data gathered in many project preparatory studies are rarely utilized for such detailed analyses. Also, poorly designed and implemented WTP studies, especially in developing countries, may provide misleading information on project feasibility and sustainability. The chapter aims to provide a set of guidelines for conducting contingent valuation (CV) studies in the WSS sector. It covers preparations in planning a CV study, study design (sampling strategy, contingent market scenarios, and the survey instrument), survey implementation, data management and validation, and utilization of results for the analysis of effective demand and other policy-relevant issues.

To showcase good practice in action, Chapter 5 assesses the WTP for water in Sri Lanka. It illustrates how good practices discussed in Chapter 4 were employed in conducting a CV study for assessing demand and designing tariffs for improved water services. The chapter also shows how the results of the study were used to facilitate the design of a public-private partnership to provide WSS services in two areas in the southwest. The chapter describes the preparatory work undertaken for the CV study, presents study design issues focusing on the measures taken to reduce potential biases, and discusses how the CV study was administered and implemented. It also illustrates how supplementary survey information is used to evaluate households’ effective demand for improved service, preference for the institutional provider, the feasibility of a spatially based pro-poor service delivery, affordability to the poor, and acceptability of the improved service under scenarios of different connection charges and different tariff and subsidy options to design appropriate pro-poor services.

Chapter 6 details the economic analysis of integrated urban services projects, elaborates on the application of techniques discussed in Chapters 4 and 5, and presents a case study on an integrated urban services project.⁴ The chapter argues that the multi-sector nature of urban development projects requires a higher level of effort in and greater resources for economic analysis as compared to projects involving only one sector. It outlines the concepts and approaches to benefit estimation for different types of urban services specifically: district heating, solid waste management, wastewater treatment, and water supply. Focus is on the benefit transfer method, which uses data from a pre-existing analysis of the sector or from an analysis undertaken for a similar project in a different location. The chapter also provides an example of the use of hedonic pricing related to urban improvements that raise property values. The case study enriches the discussion on the cost-benefit analysis for the entire project of a multi-sector nature, on top of the analysis of the individual components.

Chapter 7 reviews the approach to the economic analysis of transport projects. Transport projects can be highly complex in nature due to their broad inter-relations with all other sectors of the economy. The chapter argues that attention should be devoted to demand forecasting, which is arguably rather crude in practice. Forecast traffic flows are often simplistically based on an extrapolation of past trends or on an assumed income elasticity of demand, linking forecast growth in gross domestic product with traffic. The chapter notes that one of the major weaknesses of demand forecasting in the current practice of transport project evaluation is the exclusion of the price effects on demand.

Another focus in this chapter is on road projects and provision of a detailed illustration of how to conduct a road appraisal. This shows how relatively simple improvements can be applied to increase the analytical rigor of the standard approach to appraisals. In terms of the methodology, the case study extends standard practice in ADB appraisals in several ways: (i) by incorporating a price effect in traffic forecasts; (ii) by including a separate estimate of developmental benefits based on future traffic; (iii) by presenting differential treatment of work and leisure time; (iv) by including passenger as well as vehicle operator time savings and incorporating labor productivity increase in valuing time savings; and (v) by incorporating a terminal value in assessing the economic viability of the project. The case study also includes the use of a software program to undertake risk analysis.

Chapter 8 illustrates key features of the economic analysis of power sector projects, focusing on the methodology for benefit valuation. It notes that the methodology for the economic analysis of power projects has not undergone major changes since the late 1980s. Benefit estimation, in particular the WTP for incremental energy consumption, continues to rely on simple approximations. Use of demand information generated from econometric techniques in assessing benefits has been rare despite increased availability of demand functions for electricity in developing countries. Using a simple demand-supply framework, the chapter discusses the methods of estimating benefits for two categories of power generation—serving new markets and reduction in power shortages—as well as of power projects built to reduce generation costs by displacing or rehabilitating old facilities, and to improve system reliability.

In estimating benefits of power transmission projects, the chapter distinguishes between a power transmission project which is part of the entire power system and where all aspects are interrelated and transmission cannot function in isolation; and a power transmission project which can be evaluated as a stand-alone project. Examples of the latter include the rehabilitation or replacement of an old transmission line in which the benefits of reduced transmission losses can be directly attributable to the project, and a transmission project which is a discrete component of an expansion plan and the power transmitted by the project can be identified as displacing a particular set of alternative power suppliers in a given area. The chapter also presents a brief discussion of methods for demand forecasting such as trend analysis, end-use models and customer surveys, and econometric methods.

Finally, Chapter 9 presents two case studies—power generation and power transmission—which apply the methods described in Chapter 8. Both pay attention to demand and least-cost analysis, and also perform distribution and risk analysis. The power generation project is a regional project that creates gains for more than one participating economy, whereas the power transmission project is about how to design a power investment program. The former case study discusses the distribution of benefits between participating countries in the region while the latter illustrates the estimation of benefits by distinguishing those that accrue to new residential consumers, existing residential consumers, and non-residential consumers. The latter also approximates consumer and producer surplus, and assesses how net benefits are distributed among stakeholders.

Appendix 1.1
Economic Analysis-Related Publications by the Asian Development Bank

ADB. 1997. Guidelines for the Economic Analysis of Projects. Manila.

________. 1997. Guidelines for the Economic Analysis of Telecommunications Projects. Manila.

________. 1998. Guidelines for the Economic Analysis of Water Supply Projects. Manila.

________. 1999. Handbook for the Economic Analysis of Water Supply Projects. Manila.

________. 2000. Handbook for the Economic Analysis of Health Sector Projects. Manila.

________. 2001. Integrating Poverty Impact Assessment in the Economic Analysis of Projects. Manila.

________. 2002. Integrating Risk Analysis in the Economic Analysis of Projects. Manila.

________. 2003. Economic Analysis of Policy-based Operations: Key Dimensions. Manila.

________. 2003. Economic Analysis in 2002: A Retrospective. Manila

________. 2004. Key Areas of Economic Analysis of Projects: An Overview. Manila.

________. 2004. Economic Analysis Retrospective: 2003 Update. Manila.

________. 2005. Economic Analysis Retrospective 2004: Sector Diagnosis in Education. Manila.

________. 2006. Economic Analysis Retrospective 2005: Strengthening Quality-at-Entry of ADB Operations. Manila.

________. 2007. Economic Analysis Retrospective 2006: Improving the Diagnostic Quality of Economic, Thematic, and Sector Work Underpinning Country Partnership Strategies. Manila.

________. 2008. Economic Analysis Retrospective 2007: Strengthening the Quality of Project Economic Analysis in ADB Operations. Manila.

Adhikari, R., P. Gertler, A. Lagman. 1999. Economic Analysis of Health Sector Projects: A Review of Issues, Methods, and Approaches. Economic Staff Paper No. 58. ADB, Manila.

Ali, I. 1989. A Review o...

Table of contents

• Front Cover
• Title Page
• Copyright Page
• Contents
• Foreword
• Acknowledgment
• Acronyms and Abbreviations
• 1. Introduction
• 2. Economic Analysis of Projects: An Overview
• 3. Theory and Practice in the Choice of Social Discount Rate for Cost-Benefit Analysis: A Survey
• 4. Good Practices for Conducting Willingness-to-Pay Surveys in the Water and Sanitation Sector
• 5. Assessing the Willingness to Pay for Improved Water Supply in Sri Lanka
• 6. Economic Analysis of Integrated Services Projects
• 7. Economic Analysis of Transport Improvements
• 8. Appraising Electricity Projects
• 9. Economic Analysis of Power Generation and Transmission Projects
• Bibliography and References
• Back Cover