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Introduction to Cost Benefit Analysis

(CBA)

NUFFIC training

By: Geert Smit


Geert.smit@ecorys.com

Rotterdam, 2 May 2017


Programme this afternoon

• Presentation: introduction to CBA

• Short video: example of CBA and discussion

• Presentation: appraisal and prioritization instruments

• Short assignment: CBA and CEA

• Wrap-up: conclusions
Contents of presentation introduction CBA

• Definitions

• Why CBA

• Key principles of CBA

• Place of CBA in decision-making process

• Steps of CBA

• Wrap-up
Cost Benefit Analysis (CBA)

 A method to quantify all advantages and


disadvantages of a project for society, as
much as possible in monetary values

 All effects on welfare: including social and


environmental impacts
Cost Benefit Analysis (CBA)

 CBA: a standard economic evaluation


technique
 CBA is a decision making tool, it is not a goal
by itself
 CBA is applied by many international
organisations, such as World Bank, Asian
Development Bank, etc
 It represents a way of thinking, in terms of
costs and benefits, in time and with alternative
solutions
Why use CBA?

 In order to investigate the impact of a major


public investment a (new airport or road) or
policy change (pricing policy, environmental
rules) on the welfare of the general public and
on specific actors.
 This as input for the feasibility of a project.
 To prepare a project for (external) funding.
Why use CBA?

 Internal reasons: it supports decision making


 External reasons: it is a necessary steps
towards getting a loan or grant
CBA and role for government

• Do we want to undertake this project?

• Do we want to subsidize this project or provide a loan?

• Do we want to do the project at the time proposed (or later?)

• Do we want to undertake the port project in its proposed


location & design or in an alternative way?
(assessment of alternatives)?
CBA and role for financier
CBA study gives answers to these questions:

1) Does the project need a subsidy or loan?

2) Is the project financial sustainable?

3) Who receives most revenues and other benefits and should be


(partly) financing the project?

4) Is the project good for society and can we justify a subsidy


(paid by taxpayers)?
Basic principles of CBA?

 Monetary values of the consequences of an


intervention
 Incremental approach -> comparing a base
case with a project case
 Cost and Benefits together reflect the changes
in individual and social welfare that result from
implementing alternative interventions
Feasibility study

• Institutional feasibility: is the set up for project implementation


sound?

• Technical feasibility: what technical options are relevant and


advised on preferred option(s), site investigation

• Financial feasibility: is the project financial viable from viewpoint


of investor or operator? (financial CBA)

• Economic feasibility: is the project good for society? (economic


CBA)

• Environmental impacts
Place of CBA in the feasibility study
12

Feasibility Study

Institutional Technical

CBA
CBA

Economic
Environmental

Financial
CBA in decision-making process
Project Cycle Management: PCM
• Project Cycle Management is an approach to
managing projects. It determines particular
phases of the Project, and outlines specific
actions and approaches to be taken within these
phases.
• The PCM approach provides for planning and
review processes throughout a cycle, and allows
for multiple project cycles to be supported.
PCM: the project cycle

MCA
CEA

Tools

CBA
PCM: principles

• Key decisions, information requirements and


responsibilities are defined at each phase.
• The phases in the cycle are progressive – each
phase needs to be completed for the next to be
tackled with success.
• New programming draws on evaluation to build
experience as part of the institutional learning
process.
PCM: programming phase

• Based on analysis of the country’s problems


and opportunities, the sectoral and thematic
focus is agreed, and ideas for projects and
programmes are broadly outlined.
• The outcome is a Country Strategy Paper or a
Country Strategy.
PCM: identification phase

• Within the framework established by the Country


Strategy Paper, problems, needs and interests of
possible stakeholders are analysed and ideas
for projects and other actions are identified
and screened for eventual further study.
• Sectoral, thematic or “pre-feasibility” studies
may be done to help identify, select or investigate
specific ideas, and to define what further studies
may be needed to formulate a project or action.
• The outcome is a decision on whether or not the
op-tion(s) developed should be further studied in
detail.
PCM: appraisal phase-1

• All significant aspects of the idea are studied,


taking account of the orientations of the Country
Strategy Paper, key quality factors and the views
of the main stakeholders.
• Beneficiaries and other stakeholders should
actively participate in the detailed specification
of the project idea. Relevance to problems, and
feasibility, are key issues.
PCM: appraisal phase-2

• Detailed implementation schedules, including a


Logical Framework with indicators of expected
results and impact, and implementation and
resource schedules, should be produced.
• The outcome is a decision on whether or not to
propose the project for financing.
PCM: financing phase

• The financing proposal is completed and


considered by the appropriate internal or external
committee; and a decision is taken whether or
not to fund the project.
• A formal agreement with the partner Government
or another entity is then signed by both including
essential financing implementation
arrangements.
PCM: implementation phase

• The agreed resources are used to achieve the


project purpose (= the target group(s) receive
the planned benefits) and the wider, overall
objectives. This usually involves contracts for
studies, technical assistance, works or supplies.
• Progress is assessed (= monitoring) to enable
adjustment to changing circumstances. At the
end of implementation, a decision should be
taken to close or ex-tend the project.
PCM: evaluation phase
• Evaluation is an assessment, as systematic and
objective as possible, of an on-going or
completed project, programme or policy, its
design, implementation and results.
• The aim is to determine the relevance and
fulfilment of objectives, developmental
efficiency, effectiveness, impact and
sustainability.
• An evaluation should lead to a decision to
continue, rectify or stop a project and the
conclusions and recommendations should also
be taken into account when planning other
similar future projects.
PCM: major documents and decisions
PCM: major documents and decisions

Ranking

Selection
Guidelines and practices CBA of donors

• World Bank: feasibility studies: CBA as part of financial-


economic chapter

See example ToR in materials

• ADB: detailed guidelines on economic assessment of projects

See ADB guideline in materials

• JICA: Use of NPV and IRRs, social analysis for ODA loan
projects (surveys)

See JICA guidelines for project evaluation in materials


Main steps in carrying out CBA

Step 1. Definition of the problem, project objectives and project


alternatives

Step 2. Establish the baseline (or “counterfactual”)

Step 3. Option analysis

Step 4. Financial analysis (or the ‘business case’)

Step 5. Economic analysis

Step 6. Perform ‘risk and sensitivity analysis


Step 1: Defining problem, objectives and
alternatives

• Socio-economic context and the key problems?

• What are the key objectives of the project?

• Is the project relevant for solving the problem?

• Are there any alternatives for solving the problem?

Problem
tree
Step 2: Establish the baseline

• Time-horizon and economic lifetime of project (20-30 years?)

• Baseline scenario: demography, economic growth, technology


developments relevant for demand analysis

• Business as usual policies relevant for the project

• Demand without the project (traffic development etc.)

Baseline and effects of


crisis
Step 3: Option analysis

What options for reducing the problem are considered?

• Do minimum alternative: cheaper smaller scale solutions, use


of existing facilities

Global alternatives:
• Non investment policy instruments (regulation, pricing etc.)

What kind of project alternatives?


• Different scope and scale
• Different locations (sites) or routes (transport)
• Different technologies (high speed rail, conventional etc)
• Alternatives because of various operational concepts; stations,
frequency, recycling& composting etc.
• Alternative managing and/or pricing solutions
• Timing and phasing of project components
Step 4: Financial Analysis

• What is the project’s commercial profitability?

• What amount of finance is needed and how will the


project be financed?

• What will be the subsidy?

• Will the project be financially sustainable?


Step 5: Economic analysis:
socio - economic costs & benefits of projects

• Contribution of the project to wellfare (well being) of the country or


region: so all impacts are in principle included

• Perspective: society

Types of impacts:

• Market impacts: for users and suppliers on the market of project


services

• Non market impacts: no market price available: environmental


impacts, social impacts (“externalities”)

• Indirect impacts: priced impacts for other markets/actors


Outcomes CBA
Decision rules government

E IRR< r E IRR > r

F IRR < No go Subsidize


r

F IRR >
Tax No
r
goverm.
subsidy
Step 6. Risk and sensitivity analysis

• External risks (political, economic, demographic)


• Project internal risks (technical, organizational etc)

Selection of important factors which influence the results (NPV of


IRR):

Sensitivity analysis: impacts of different factors on outcomes


demand, FA, CBA
• Scenarios future amount of demand (traffic or water/ energy
consumption)
• Discount rate
• Higher financial costs etc.
Wrap-up

• CBA is a decision making tool.

• CBA is used for internal (decision-making) and external purposes


(financing).

• Feasibility studies are useful for decisions of government (project


selection, timing, size)

• Feasibility studies can help to improve projects (timing, size)


Further reading
• Guidelines for the economic analysis of projects, Asian Development Bank
Economics and Development Resource Center, 1997
• EU (European Commission), DG Regio CBA Guidelines 2008
http://ec.europa.eu/regional_policy/sources/docoffic/working/sf2000_en.htm
• UK Green book of HM Treasury, downloadable at http://www.hm-
treasury.gov.uk/media/05553/Green_Book_03.pdf

Some good CBA handbooks:


• Boardman A. E., Cost-Benefit Analysis. Theory and practice, 3rd edition,
Pearson, 2006. Probably the most comprehensive and up-to-date introductory
text (in a partial equilibrium setting).
• Brent R.J., Applied Cost-Benefit Analysis, new edition forthcoming, Edward
Elgar. A text well grounded in applied welfare economics, with some original
approaches.
• Pearce D., Atkinson G., Mourato S., Cost Benefit Analysis and the
Environment. Recent Developments, OECD Publishing, 2006.
Short video on CBA

• Watch video
• Discussion on key aspects of CBA
Contents of presentation appraisal and
prioritization instruments

• Different needs, different instruments

• Identification phase: MCA, CEA

• Appraisal phase: CBA

• Differences in application

• Wrap-up
Different needs, different instrument

• Identification of projects

• Ranking of projects: Multi Criteria Analysis


1 2 3 4 5
(MCA) and Cost Effectiveness Analysis (CEA)

• Appraisal of a project: Cost Benefit Analysis Yes-


1
(CBA)
no
PCM: the project cycle

MCA
CEA

Tools

CBA
Cost Effectiveness Analysis
(CEA)
1 2 3 4 5
Cost Effectiveness Analysis (CEA)

• CEA is used when policy goals are fixed (more 1 2 3 4 5

security, less noise levels): the cheapest way to


reach those goals
• Example: reduction of road casualties ->
measures that contribute towards this objective
vs costs needed per measure
• No other effects taking into account
When use CEA?

• CEA is used in case of single objective 1 2 3 4 5

• Then: ranking of alternatives

• Not to be used for justification of individual


project
Example CEA: road safety improvement

1 2 3 4 5

Road A Road B

Road length (km) 20 30


Cost of road improvement
(EURO/km) 30,000 30,000

Reduced casulaties 10 20
Cost Effectiveness Ratio
(EURO/person saved) 60,000 45,000
Multi Criteria Analysis
(MCA)
1 2 3 4 5
Mutli Criteria Analysis (MCA)

 Compares alternatives by giving scoring and 1


Yes-
weighing defined criteria
 Also here: ranking of alternatives (not no
justification of individual project)
 No need for monetarisation, nor quantification
Mutli Criteria Analysis (MCA)

 Options (different projects or measures) 1


Yes-
 Defining criteria
 Weights per criteria and standardization or no
intervals of potential scores
 Scores per option on the defined criteria

 MCA matrix
Example MCA

Road 1 2 3 4 5
rehabili- New rolling
Criteria weight tation* stock rail*
Economic impact 8,2 12,7
(EIRR) 0,6 2 – 1,2 3 – 1,8
12,000 4,500
Employment created 0,3 3 – 0,9 1 – 0,3
++ 0 *Impact
Readiness to start 0,1 2 – 0,2 0 – 0,0 scores: 0-3
2,3 2,1
Rank 1,0 Rank 1 Rank 2
Differences CEA and CBA
CEA CBA
• Both
Investment Investment
costs costs instruments
can be used for
Maint. and Maint. and ranking
oper. costs oper. costs
projects, only
Specific effect Specific effect CBA can be
or benefit or benefit used for
appraisal
Other effects • CEA based on a
single objective
Differences MCA and CBA
MCA CBA • Both instruments
can be used for
Investment Investment ranking projects,
costs costs only CBA can be
used for appraisal
Maint. and Maint. and
oper. costs oper. costs • CBA expresses all
costs and benefits
Specific effect Specific effect in monetary values
or benefit or benefit • MCA defines
criteria which can
also be expressed
Other effects Other effects in qualitiative
terms
Wrap-up session 2

• Support instruments or tools can be applied at various


stages of the project cycle:
– Ranking or prioritisation: MCA and CEA
– Appraisal of individual projects: CBA
• Specific tools for specific needs (all tools have their pros
and cons)
Thanks!