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Warning: Popup annotation has a missing or invalid parent annotation.ECONOMIC ANALYSIS OF INFRASTRUCTURE INVESTMENTSIntroductionInfrastructure is the basic physical systems of a business or nation eg transportation, communication, sewage, water and electric systems are all examples of infrastructure...

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ECONOMIC ANALYSIS OF INFRASTRUCTURE INVESTMENTS Introduction Infrastructure is the basic physical systems of a business or nation eg transportation, communication, sewage, water and electric systems are all examples of infrastructure. These systems tend to be high-cost investments, however, they are vital to a country's economic development and prosperity. Infrastructure projects may be funded publicly, privately or through public-private partnerships. Read more: Infrastructure Definition | Investopedia http://www.investopedia.com/terms/i/infrastructure.asp#ixzz3ycfMoZln Follow us: Investopedia on Facebook

The economic problem of allocating limited resources to various needs often requires decisionmaking about appropriate investments. Choices have to be made among competing investment opportunities. This assumes greater importance for infrastructures supply investments given their large sizes and capital intensiveness. The basic analytical framework is the cost-benefit analysis—where costs and benefits over the lifetime of the project are evaluated and investments with positive net benefits are considered to be acceptable investments While the financial analysis uses a similar framework and is more widely used for private investments, the economic analysis is important for investments in the public sector or for those with public or near-public good characteristics. This chapter provides an introduction to the economic analysis of infrastructure investments and highlights various important aspects related to such an analysis. Main Characteristics of InfrastructureProjects Infrastructure projects share a number of important features: a) Capital intensiveness: Infrastructureprojects tend to be capital intensive as the initial investment requirement is often high. For example, electricity industry is two to three times capital intensive compared to the manufacturing industry.

b) Asset specificity: The assets in the infrastructure industry tend to have a high degree of specificity, implying they are less re-deployable in nature. This means that they do not have alternative uses other than their use in the infrastructuresector. This specificity makes assets vulnerable to risks.

c) Long-life of assets: Most infrastructure investments live long; for example, a conventional power plant can easily operate for 25 years, a hydro power plant can live 50 years, even a diesel plant can operate for more than 10 years. As the life increases, the uncertainty about the future costs and benefits increases.

d) Long gestation period: Infrastructure projects take longer to build; for example a nuclear power plant can easily take 8–10 years to construct, a dam can also take such a long period. Any changes in the business environment during the construction could jeopardize the investment. Similarly, it requires investment decisions to be made well in advance, so that the assets are brought into operation at the time of need. This requires that any investment decision has to be based on projected market conditions at a relatively long future date, making the decision-making vulnerable. e) Big size: Often energy projects tend to be big to take advantage of scale economies (i.e. big is beautiful). As a result, the capital outlay increases even where the capital cost per unit is low.

Relating Infrastructure Sectors in SSA. Relationship between Infrastructure and other Sectors of the Economy a. Infrastructure & Agriculture in Sub-Saharan African Countries b. Infrastructure & Health in Sub-Saharan African Countries c. Infrastructure & Education in Sub-Saharan African Countries Costing Infrastructure Services/projects

Because of these features and the importance of infrastructure sector investments in the economy, an economic analysis of infrastructure investments is essential.

Basics of the Economic Analysis of Projects

The economic analysis of projects aims at ranking projects so that economically effective projects can be identified and selected for better allocation of resources. Given the noncompetitive environment prevailing in the infrastructure sector in many countries and because the costs and benefits of infrastructure sector projects may go beyond the project boundary, a systematic method of evaluation is important. •

Whether the project should be undertaken by the public sector or the private sector;

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The fiscal impacts of the project;

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The efficiency and equity of cost recovery; and

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The environmental impacts of a project.

Thus an economic analysis is aimed at analyzing the welfare impacts of a project. An economic analysis essentially involves three elements. a) Identification and estimation of costs related to an investment, b) Identification and estimation of the benefits to be obtained from the investment and c) Comparing the costs with benefits to determine the appropriateness of the investment. If the benefits exceed the costs, investment in the project isacceptable, otherwise it is not. The first two elements form the core of the analysis and normally require detailed investigations for identification, quantification and valuation of costs and benefits.

Project-related costs and benefits are identified by considering and comparing two cases or situations: with-project scenario and without-project scenario. Implementation of any project will reduce the supply of inputs and increase the supply of outputs. The difference in the availability of inputs and outputs in two situations forms the basis for identification of costs and benefits of a project in economic terms.

Similarly, a distinction is made between non-incremental and incremental outputs: Incremental outputs are obtained by expanding the supply to meet the demand whereas nonincremental outputs replace the existing production. Similarly, incremental and non-incremental inputs are also distinguished: incremental inputs come from an increase in the supply of inputs while the non-incremental inputs compete with the existing input supply and not through an increase in the input supply. As these aspects affect the

overall economic viability, these important distinctions need to be kept in mind while identifying the costs and benefits. Identification and valuation of costs and benefits could start from the financial statement of the project entity, but two types of adjustments are normally made for economic analysis: (a) Certain costs and benefits are either excluded or included and (b) The valuation of certain items would change from financial to economic values.

Cost means different things to different people. In an economic analysis, care has to be taken about the certain costs. Normally those costs which impose additional cost burdens are considered in the economic analysis. Some of these elements are as follows: Sunk costs: If a project uses already existing facilities, for which investments have already been made (i.e. sunk), the economic analysis would exclude these costs as they do not represent any additional costs for the project. Theseexisting facilities would exist even without the project and hence they impose no extra burden to the project.

Contingencies: The part of the contingency that represent additional claims on resources for the project would be included in the economic analysis. As the economic costs are measured in constant price terms (as opposed to nominal terms in financial calculations), the price-related contingencies are not included in the economic analysis. Working capital: The same logic for contingencies applies here. For economic analysis, the costs that represent real claim on national economic resources would qualify for inclusion. Any transfer payments would have to be excluded.

Transfer payments: These are payments which ‘‘transfer command over resources from one party to another without reducing or increasing the amount of resources available as a whole’’. Examples include taxes, duties and subsidies which in most circumstances would be considered as transfer payments. As they do not put any addition claim on the resources, they are not

considered in economic analysis. However, taxes (duties and subsidies) would be included in the price if the demand for inputs is non-incremental, or if the output is incremental or if the government tries to internalize externalities through the tax. Depreciation: The economic analysis uses the initial cost of an asset less the residual value (discounted). This fully reflects the cost of using an asset and does not pay any attention to the funding of the resource and its repayment.Accordingly, depreciation is not considered in the economic analysis.

Depletion premium: For non-renewable resources, the economic analysis includes the depletion rent to reflect the economic cost to the society of using such resources. The opportunity cost of the resource includes the cost ofsubstitutes at the time of exhaustion. External costs: As infrastructureprojects often generate externalities the cost of which are not borne by the users but the society as a whole, the economic analysis includes such external costs to arrive at the full economic costs ofusing the outputs. An economic analysis is incomplete without taking this into account.

Some of these elements (such as external costs) are often difficult to value in monetary terms. However, attempts should be made to include such costs to the extent possible. Identification of Benefits The output of a project which is sold in the market generally constitutes the main benefit of a project. When the output is incremental, the project does not affect the market price and is considered as a price taker. This is the case when the project output is relatively small compared to the market size and the product is tradable. On the other hand, for non-tradable goods, the supply tends to be non-incremental (displacing) and the project output could influence the market price.

In some cases, projects lead to directly productive and indirectly productive outputs. For example, a dam can provide recreational facilities in addition to electricity generation, irrigation

water or drinking water supply. These additional benefits may be difficult to value in monetary terms but should be considered. A project benefit may also include any changes in consumer surplus. This captures the difference between what consumers are willing to pay and what they actually pay for a good or service. However, care has to be taken to include only that part which benefits the society as a whole. For example, if a hydro power plant reduces electricity price and increases the demand for electricity, it generates consumer surplus. But the price reduction produces revenue loss to utility and therefore has an off-setting effect. The net surplus should be considered in suchcases.

Valuation of Costs and Benefits Once the costs and benefits are identified, they are valued using appropriate economic prices that represent the value to the national economy. Consequently, the valuation could be different from that used in the financial analysis. As an economic analysis intends to determine the costs and benefits to the society (or national economy) rather than to the suppliers or buyers, the true economic price has to be used in the analysis. Valuation of Project Inputs and Outputs One of the adjustments made to the market prices in the economic analysis is the use of shadow prices. The shadow price is the price that would exist if the market operated perfectly and allocated resources efficiently. Distortions exist in all economies due to lack of competition or inadequate competition, government intervention (to tax or provide subsidies, to protect suppliers through duties or quotas, to control prices, to control foreign exchanges or wages, etc.) or the presence of externalities. As the infrastructure sector is often characterized by these market failures or government interventions, prices in the market do not reflect the true value of energy project inputs and outputs. The output of the project displaces some existing supplier and substitutes their output (shown by Qwo-Qe) and meets the incremental demand (Qw-Qwo). Thus, the output of the project can be considered in two parts: non-incremental (the first component which displaces existing supply) and incremental (the second componentthat is used to meet the incremental demand).

Price

Sw0 DProject Output Pricing Sw

Pw0 Pw D Qe

Qw0

Qw

Qty

The valuation of the non-incremental output (i.e. the output which substitutes alternative supply) is based on the adjusted supply price for the alternative supply because in absence of the project consumers would have paid that price. Adjustments to the market price have to be made to take care of any taxes and subsidies as well as for market imperfections or government controls. On the other hand, the economic price for the incremental output is the adjusted demand price for the output adjusted for taxes, subsidies and other market imperfections or government interventions.

Similarly, the project inputs also bring changes to the economy. The demand for inputs moves outwards as a result of the new project. This causes prices to increase for the inputs as the demand for inputs increases (see Fig. 7.2). Once again, the effect has two elements: incremental demand (Qw-Qwo) where the project introduces additional demand for inputs and nonincremental demand (which moves existing supply to the project). Price

Dw

S

Dw0 Project Input Pricing Pw Pw0

Qw0

Qw

Qty

The valuation of non-incremental inputs would be based on the adjusted demand price of the alternative supply that is substituted, because the project increases the willingness to pay for the inputs compared to without project situation. For the incremental inputs, the adjusted supply price would apply.

Border Prices for Traded Goods Given that some infrastructure products are traded internationally (e.g. oil) while others are essentially non-traded (e.g. electricity), the effect of the international trade on prices would have to be considered. The possibility of participation in the international trade allows the project output to be exported, project inputs to be imported or exported/imported goods can be substituted. Accordingly, four situations can be considered for traded goods: a) Exportable project output—in this case, if the size of the project is small compared to the world market, the demand faced by the project output is infinitely elastic. Consequently, the output is incremental and the appropriate price for valuation is the free on board price at the port of delivery, as the project is unable to influence the prices in the global market.

b) Import-substitute output—when a project output replaces imported goods, the opportunity cost is the foreign exchange saved and the appropriate price is the cost in foreign (CIF) price of the goods. c) Imported input—the supply faced by an imported input is infinitely elastic and as a consequence an additional demand does not influence the world price as long as the project input demand is small compared to the world supply. The relevant price is the CIF price.

d) Exportable input—in absence of the project, the input would be exported and accordingly, the opportunity cost (i.e. the benefits foregone) for the input in using it in the project is the Foregone Output Benefit (FOB) price of the input. Adjustments are made to take account of processing, transportation and handling charges.

Economic Prices of Non-Traded Goods Non-traded goods are produced and consumed locally. This may arise due to absence of international market, trade restrictions and the nature of the industry.

a) If non-traded goods used as project inputs increase the supply for the inputs (i.e. incremental inputs), the appropriate price is the marginal cost of supply. When excess supply capacity exists, the marginal cost is the variable cost of supply but the capacity is constrained, the marginal cost would include both variable and capacity costs. b) If the non-traded inputs are non-incremental in nature, the willingness to pay principle has to be applied. For non-traded outputs the pricing principle changes as follows: (a) For incremental outputs (i.e. which increase the supply to meet additional demand) the value to the consumers is used as the price (i.e. the demand price.) with proper adjustment for taxes and subsidies. (b) Non-incremental outputs on the other hand should be valued at the cost of supply of the displaced output in absence of the project.

Economic Price of Labour Labour being an important component of any project, its economic valuation is important because of the distortions in the labour market. In a situation of full employment and perfect competition, the cost of labour is market determined. However, in reality this is hardly the case. In general, it is often found that some labour is scarce (mostly the skilled labour) and it is easy for them to find alternative jobs. In such a case the opportunity cost of the labour has to be considered which would be the price at which the labour is willing to work, adjusted for any distortion in the market due to government control. For other types of labour, there is generally

oversupply and this situation could exist due to government wage control (or intervention) in the labour market (see Fig. 7.3) in the organized sector or due to other factors. Wage D

S

W2 W1

q2

q1

q3 Labour

The supply and demand of labour would clear at the wage rate W 1 but the wage control in place requires the wage to be W 2. This high wage attracts more labour to the market, thereby increasing the supply to q3 but the demand for labour falls to q2. Consequently, the involuntary unemployment is created to the tune of q2–q3. If the project employs unemployed labour from the controlled segment, the economic price should be the market clearing wage. But given that it may be difficult to determine the market clearing wage, alternative information (such as remuneration from alternative activities undertaken by the labour) could be used. This could come from employment in the informal sector, subsistence activities or seasonal works. The shadow wage rate for labour is the estimation of the economic wage rate of labour used in the project. Fig. 7.3 Involuntary unemployment of labour

Economic Price of Land Any project would use land and its economic valuation is essential to reflect the correct economic value of this resource. The appropriate price for land is the opportunity cost—the best alternative use foregone to develop the project (i.e. by comparing with without-project situation). For rural areas, this would imply the cost of agricultural output foregone valued at the economic

price of the output. In the urban areas where the project may displace industrial and commercial activities, or residential housing or other amenities, the loss in economic activities orthe willingness to pay for the amenities could give the economic value of the land. Economic Price of Foreign Exchange The valuation of project inputs and outputs can be done in the local currency or in a foreign currency. Either way, the exchange rate plays a role as in the case of local currency valuation, all imported and exported goods have to be converted to the local currency using the foreign exchange rate. In a competitive market, the foreign exchange rate is decided by the interaction of supply and demand for currencies. However, often the market is not competitive and governments intervene either by fixing a rate or by rationing the supply. Figure 7.4 indicates that if the rate is fixed at P2 or if the supply is restricted to q2 artificially, the true cost to the economy is P1, which would be...