D 5.1.2 Framework for cost benefit analysis - · PDF fileColofon Title FRAMEWORK FOR...

FRAMEWORK FOR OPERATIONAL COST BENEFIT ANALYSIS IN WATER SUPPLY

TECHNEAU MARCH 2008

TECHNEAU

© 2006 TECHNEAU TECHNEAU is an Integrated Project Funded by the European Commission under the Sixth Framework Programme, Sustainable Development, Global Change and Ecosystems Thematic Priority Area (contract number 018320). All rights reserved. No part of this book may be reproduced, stored in a database or retrieval system, or published, in any form or in any way, electronically, mechanically, by print, photoprint, microfilm or any other means without prior written permission from the publisher

FRAMEWORK FOR OPERATIONAL COST BENEFIT ANALYSIS IN WATER SUPPLY

JULY 2007

Colofon

Title FRAMEWORK FOR OPERATIONAL COST BENEFIT ANALYSIS IN WATER SUPPLY Author(s) Barbara Baffoe-Bonnie (WRc), Thom Harle (WRc), Ed Glennie (WRc), Glenn Dillon (WRc), Frøydis Sjøvold (SINTEF) Quality Assurance By Sveinung Saegrov (SINTEF) Deliverable number D5.1.2

This report is: PP = Restricted to other programme participants (including the Commission Services).

CONTENT

1 INTRODUCTION 2 1.1 TECHNEAU 2 1.2 Work Area 5 3

2 OPERATIONAL COST BENEFIT ANALYSIS 4 2.1 Purpose of Paper 4 2.2 Brief Introduction to Cost-Benefit Analysis (CBA) 4 2.3 Application of CBA in the Provision of High Quality Water 4 2.4 CBA Methodology for Operations and Maintenance of various TECHNEAU

Improvement Techniques 6 2.4.1 Identification of water supply issues 8 2.4.2 Identification of strategies and interventions 8 2.4.3 Identification of relevant costs and benefits of an intervention 9 2.4.4 Valuation of costs and benefits 11 2.4.5 Using economic valuation techniques to measure benefits of an improvement in water quality 13 2.4.6 Discounting the future stream of costs and benefits 15 2.4.7 Decision Criteria – Net Present Value, Benefit Cost Ratio 16 2.4.8 Incorporating risks and uncertainty into a CBA Framework 17 2.5 Incorporating Carbon footprint and Whole Life Costing in a CBA framework 18 2.6 Case Study: Using CBA to measure the net benefits of water quality improvement 20 2.7 Discussion 21 2.8 Conclusion and recommendation 22

3 REFERENCES 24

TECHNEAU © TECHNEAU - 1 - March 2008

1 INTRODUCTION

1.1 TECHNEAU

TECHNEAU is an Integrated Project funded by the European Commission within the scope of the EU 6th Framework Programme and will be conducted by a consortium of 30 universities, research institutes and technology suppliers from Europe and developing countries. It was launched in January 2006 and will run for 5 years. TECHNEAU will develop and demonstrate adaptive supply system options and new and improved supply and monitoring technologies and management practices. Treatment strategies will be based on robust multi-barrier schemes and control methodologies, providing safety against a broad spectrum of chemical and microbiological contaminants and avoiding organoleptic problems at the tap. Monitoring technologies will provide ‘on-line’ and ‘at the site’ information on water quality including parameters that relate to malicious contamination. Practices for risk assessment/risk management, operation and maintenance, and models for consumer acceptance will constitute the framework for these technologies. These technologies and management practices will enable end-users to make informed choices, appropriate to their own circumstances and constraints, for cost-effective and sustainable source-to-tap solutions for the provision of safe high quality drinking water that has the trust of the consumer. TECHNEAU is based around a series of linked Work Areas, as shown below:


1.2 Work Area 5

Work Area 5 (WA5) aims to address and improve the operational performance of existing water treatment and distribution systems. It is important that the costs of any measures undertaken by a utility to improve operational performance can be justified. Work Package 5.1 (WP5.1) has the overall objective to develop a methodology for cost-benefit analysis (CBA) to prove the efficiency of any operational improvements.


2 OPERATIONAL COST BENEFIT ANALYSIS

2.1 Purpose of Paper

WP 5.1 has the overall objective of providing a methodology to prove the efficiency and benefits of operational methods and maintenance schemes developed and improved in TECHNEAU (with regards to water quality, reliability of water supply, customer service, etc.). The purpose of this paper is to provide a basis from which to make informed decisions about how best cost–benefit analysis (CBA) can be applied to evaluate the remedial options implemented at end–user sites to make improvements to the water supply systems.

2.2 Brief Introduction to Cost-Benefit Analysis (CBA)

CBA is an economic tool for evaluating all relevant costs and benefits of an investment, reflecting the total impact of a project on society as a whole. It started out of a need to quantitatively assess whether a business or society at large would experience a net benefit from a given project. The methodology entails the systematic estimation of all benefits and all costs of a contemplated course of action in comparison with alternative courses of action.

CBA considers gains and losses to all members of the community who are affected by the project being considered. The analysis should not concentrate solely on the financial implications of a project but other tangible and intangible externalities must be assessed.

Key elements of a CBA: • To allow a comparison between alternative options, benefits and costs need to be

valued in a consistent manner. The common unit of measurement is usually money. • Not only do the benefits and costs of a project have to be expressed in terms of

equivalent money values, but they have to be expressed in terms of money at a particular time. Future costs and benefits are, therefore, discounted.

• Valuation of benefits and costs that do not have a clear monetary value should represent peoples’ behaviour or choices.

• The analysis of a project should include the ‘without-project’ option. This is the situation that would occur if current schemes continued and no new interventions were introduced.

• A performance or decision criterion is required. The common criteria used are the Net Present Value (NPV) and Benefit Cost Ratio (BCR).

2.3 Application of CBA in the Provision of High Quality Water

CBA is increasingly being used in the water sector to justify investment needs and improvements of water quality (and other serviceability parameters). It provides a structured comparison of all the costs and benefits when deciding on the optimum level of water quality improvement schemes. The best strategy or option for improving water quality can be found graphically by comparing the cost of improvement in water quality


with the value of the benefit of the improvement (see Figure 1). The point where the distance between the two plots is greatest is the “maximum net benefit”.

Figure 1 The Cost Benefit Analysis (CBA) “fish” diagram

The economic regulator of the water companies in England and Wales, Ofwat, supports the wider application of CBA and is increasingly encouraging water companies to adopt this approach in justifying their investment needs (Consultation Paper RD 04/06) (Ofwat, 2006). One of the most important elements of this approach is the need to measure the willingness-to-pay of the consumers under different levels of service to optimise the social net benefit delivered by a project.

In addition, the UK Water Industry Research (UKWIR) report on “Acceptability of Drinking Water to Customers” (07/CU/02/3) sought among other things to formulate interventions and seek funds to address aesthetic aspects (including discoloration and particles, taste and odour, and hardness) of drinking water quality. A vital part of the project was the development of an appropriate methodology for justification of investment to improve aesthetic water quality by using customer WTP and CBA (http://www.ukwir.org/ukwirlibrary/91494).

The US Safe Drinking Water Act (SDWA), as amended in 1996, requires that whenever the Environment Protection Agency (EPA) proposes a national primary drinking water regulation, it must publish a CBA. Components of the analysis include treatment design, unit treatment costs and national costs, model systems development, baseline estimates, data quality objectives and benefits analysis. The SDWA also requires that the EPA fully consider both quantifiable and non-quantifiable benefits that accrue due to drinking water regulations; these benefits must be compared with the projected costs of the regulations.

Benefit of improvement

Costs of improvementMax net benefit

Increasing

Service or water quality improvement

Cos

t/Ben

efit

(mon

etar

y un

its)


http://www.ukwir.org/ukwirlibrary/91494

Development of cost information, while challenging, is fairly well understood. Benefits assessment, by contrast, is less well understood (at least in connection with drinking water regulations).

The benefits of regulatory action are reflected in improvements in human welfare. Equivalently, they represent the avoided damages or losses in welfare that humans would have experienced in the absence of regulatory action. As a part of the EPA program, a review of the economics literature pertaining to the evaluation of drinking water quality improvement benefits was performed. This review found a broad categorization of the possible benefits of drinking water regulations to include:

• Improved human health,

• Enhanced aesthetic qualities,

• Avoided costs of averting behaviour,

• Avoided materials damages,

• Avoided costs of market production,

• Non-use benefits, and

• Information benefits.

A number of benefits analysis projects are currently underway, including the preparation of a guidance manual for benefits evaluation directed towards regulation development managers. Also underway are projects on risk assessment data needs (of regulation development managers), methods of evaluating and presenting data in view of uncertainties, cost of illness for various health endpoints, and bottled water and home treatment expenditures. In addition, the new EPA benefits programme includes assistance to ongoing rulemaking efforts, such as arsenic and radon.

EPA encourages public input into regulation development. Public meetings on the development of the new benefits framework are announced in the Federal Register (http://www.epa.gov/safewater/ria/benepp.html).

2.4 CBA Methodology for Operations and Maintenance of various TECHNEAU Improvement Techniques

TECHNEAU WP5.1 has the overall objective to prove the efficiency of operational improvements by carrying out a CBA. CBA should be performed taking into account expectations and differences that exist between end–users with respect to geographic-, economic- and water supply issues, and the regulation of the water industry in each country. The project inputs and outputs should be identified, quantified and valued, comparing the “without-project” (do nothing) situation with the “with-project” situation, covering all relevant project benefits and costs.


http://www.epa.gov/safewater/ria/benepp.html

There are two parts to the CBA that need to be carried out:

• Firstly, a forecast of the costs and benefits of each option (i.e. “without project” and “with-project”, e.g. incorporating TECHNEAU operational improvements) needs to be made to convince end–users to implement (or otherwise) the operational improvements.

• Secondly, the actual costs and benefits need to be monitored and quantified after

implementation to prove the effectiveness of the operational improvements. In developing a CBA model, the following key elements of the appraisal should be identified: • A base case or “without-project” scenario which represents the current level of service

and the current cost to the Water Service Provider (WSP). This should be compared with the “with-project” scenario.

• Planning period/horizon in years for the appraisal. • Identify and estimate costs over the planning period including operating expenditure

(opex), capital expenditure (capex), social and environmental costs. This involves identifying and quantifying the cost to the WSP of the intervening mechanisms that will provide improvements to all the aspects of drinking water enhancement identified from a customer focus group.

• Identify and estimate benefits to WSP, customers, and society as a whole over the

planning period (expressed in terms of monetary benefits, cost savings or both). This involves deriving customer benefit, in monetary terms, of these improvements in aesthetic service provision through a large – scale customer willingness to pay survey.

• A discount rate to convert future values to present values. • Risk and sensitivity analysis to integrate risk and uncertainty into the framework. An outline of the phases in carrying out a CBA for a TECHNEAU operational improvement is summarised in Figure 2.


Figure 2 Stages in the development of a CBA model

2.4.1 Identification of water supply issues

Identification of key service areas depends on the nature of problems that each end–user is experiencing, or has experienced in the past, regarding the provision of safe drinking water. Also, consumers in different regions might have different preferences in relation to which service areas should be given higher priority. These would be expected to include water quality, interruptions to supply, customer satisfaction, etc. These issues can be identified from customer focus group meetings, customer satisfaction surveys and customer complaints databases.

2.4.2 Identification of strategies and interventions

The next step is to identify and select relevant strategies or actions to maintain or reduce the service risk level. This involves identifying the various technologies, developed under TECHNEAU or otherwise, that need to be put in place to address the water supply problems identified.


2.4.3 Identification of relevant costs and benefits of an intervention

All relevant costs and benefits must be identified and estimated to provide a consistent basis for the comparison of alternative options. All the costs of putting in an improvement intervention and the values of the benefits that accrue to the customers and the water supplier must be incorporated into the CBA model to measure the desirability or profitability of the project. This will, for example, provide a means of justifying any capital maintenance expenditure to improve tap water quality. The various end – users involved will have different geographical, organizational and operational backgrounds. There may also be some national variation in regulation and organizational responsibilities. These differences will give diverse information about the costs and the effects or impacts of improvements. Both tangible and intangible effects should be identified and quantified. Tangible effects refer to those that are easily identified and quantified. For example, tangible costs that might be incurred in TECHNEAU schemes include operating costs, maintenance costs, capital costs, other overhead costs, etc. Intangible effects are those to which it is difficult to attribute a monetary value or to quantify in a different way. For example, intangible effects include the value of customers’ satisfaction, health, time, comfort, etc., as a result of improvement in water quality - these are difficult to quantify. The likely cost and benefit items for TECHNEAU improvement projects and how they may be measured are shown in Tables 1 and 2. Table 1 Likely costs of water quality improvement programmes

Costs Elements Note on Estimation

C1: Capital expenditure Capital costs incurred to acquire or upgrade physical assets to undertake water quality improvement schemes.

If capital costs are involved, apply the end-user’s costs for the items concerned.

C2: Operating expenditure Operating costs include additional monitoring costs, energy costs, chemical costs, labour/manpower costs, etc.

Additional annual operating costs – depends on particular intervention.

C3: Capital maintenance This includes costs incurred on an improvement system to maintain the existing standard.

C4: Additional costs Any other additional costs including replacement costs, overhead costs, etc.

C5: External costs – social and environmental costs

May include traffic congestion costs, delay to pedestrians due to repair works, noise pollution,

Depends on the external costs identified for the particular operational improvement in the particular location of


carbon impacts of intervention, etc.

implementation. As a general rule, externalities should be included if they can be quantified, although care must be taken to ensure any unquantifiable external impacts are not completely disregarded.

Table 2 Likely benefits of improvement programmes

Benefits Elements Notes on Estimation

B1: Reduction in operating costs

Could include reduced cost of customer complaints, improvements in technology that lead to reduced operating costs at treatment works, etc.

Depends on the operational improvements implemented and the knock-on effects. A comparison of the current or “without project” operating costs and “with project” scenario could give an estimate of net operating costs.

B2: Deferment of / reduction in capital expenditure

Apply the end-user’s unit costs to build up an estimate of the capital expenditure deferred.

B3: Improvements to water supply service levels

Use consumer’s valuations of different levels of service for each relevant supply issue, e.g. supply interruptions.

WTP surveys of customers need to be performed to establish their valuations.

B4: Health benefits Good quality water will result in improved public health, leading to greater economic output generally and reduced health costs associated with water quality problems.

Realistically, only an estimate based on national statistics, supplemented by research information from the WHO, can be made. Cost effectiveness analysis is an ideal tool.

B5: Improved aesthetic qualities

This involves estimating the value of improved aesthetic qualities, such as taste and odour, to customers.

The value users place on improved tap water could be estimated based on customer interviews (customer surveys) or from the findings of previous studies of this type.

B6: Public goodwill of water company

Based on consumers’ perception and confidence in the utility due to fewer supply interruptions, fewer complaints as a result of improve water quality.

Use record of customer complaints.


Note: Benefits B4 and B5 will have overlaps with B3, thus care would need to be taken to ensure “double counting” of these benefits does not occur. For example, a consumer may be willing to pay more for improved taste and odour so they no longer have to buy bottled water.

As a simple example, Tables 3 and 4 give the typical cost and benefit elements to consider when undertaking mains cleaning to eradicate discoloration of water arising from distribution. Mains cleaning involves the removal of silts, biofilms and other loose deposits from the inside of the mains, thus ensuring that these deposits will not affect the appearance of the water following any disturbance to the main (planned or unplanned). Mains cleaning includes air scouring, flushing, foam swabbing and rubber plunging.

Table 3 Costs of Mains Cleaning

Costs Elements

Capital Expenditure (C1) Capital expenditure would be the costs of the equipment and fittings required for the cleaning to be carried out. This could include the cost of purchasing cleaning apparatus (swabs, plungers, etc.), vehicles and washouts. Capital expenditure would also include the cost of preparatory works to the network, e.g. the installation of washouts to allow flushing to be undertaken.

Operating Expenditure (C2) There would be a significant cost associated with the operation of this intervention. This would include planning and supervising the work, labour and transportation. Opex could also include the cost of water that is lost from the network during the cleaning activity.

Capital Maintenance (C3) Capital maintenance costs could include the cost of maintaining or replacing the mains cleaning equipment.


Table 4 Benefits of mains cleaning

Benefits Elements Reduction in customer complaints (B1)

(Public goodwill of water company B6))

Potential annual savings due to reduction in complaints as a result of improve water quality. More stable water quality.

Potential change in other operating costs

This involves the impact that mains cleaning could have on other operational activities within the service area under consideration. E.g. expected prolonged pipe life expectancy.

Benefits to customers: Improved aesthetic qualities (B5)

Results of economic valuation of the values consumers place on an improvement in water quality.

Health benefits with reduced biofilm (B4) Potential health benefit, with reduced potential for pathogens to “hide” in biofilm.

Reduced sediments that can cause difficulties in fire fighting

Accumulation of sediments in the mains can potentially be re-suspended when big variations on flow. E.g. can cause plugged fire hoses (the device that spreads the water) in a fire fighting situation.

External costs: social & environmental Social and environmental costs could consider the loss of public image due to perceived waste of water by customers, possible pollution of water causes from the flushed water. One should also consider costs related to potential risks from different cleaning techniques, e.g. rough techniques with use of hard plugs might cause “bleeding” from removed rust nods in cast iron pipes.

2.4.4 Valuation of costs and benefits

Monetary valuation is a key component of CBA. Economic values expressed in monetary terms, if properly determined, will reflect people’s preferences and can thus be used as weights to inform any policy analysis or decisions. After identifying all relevant costs and benefits, the next step is to assign monetary values to the costs and benefits of each option in terms of the price level prevailing in the year in which the project is appraised.


It is however difficult to place monetary values on non-financial benefits such as health benefits or aesthetic benefits. For example, it is not possible to quantify or estimate in real monetary terms the value of an elimination of odour in water supply or the value of human lives potentially saved due to improvements in water quality. This is because a market does not exist, or market prices are not directly observable or easy to estimate. Many water quality benefits cannot be directly measured through the market system; therefore non-market methods have been developed to assess them. Consequently, a number of economic valuation tools and techniques can be employed to estimate the value that is placed on these non-market goods. Section 2.4.5 gives a summary of the economic valuation techniques that can be employed to estimate the value that customers or users place on an improvement in water quality.

2.4.5 Using economic valuation techniques to measure benefits of an improvement in water quality Economic valuation refers to the assignment of monetary values to non-marketed assets, goods and services. Reliably estimated monetary values for non-marketed goods will reflect people’s willingness-to-pay for (or accept) certain changes. WTP represents the expected payment a user is willing or prepared to pay for a given service/product or a given change in service level or product attribute. It is the price at which they would be indifferent between having the service/product or the money. An individual would not purchase the service/product at an amount greater than his/her WTP. In the context of a water utility, WTP represents the amount that a customer would be willing to pay for proposed improvements in water services over a defined baseline of service. The two main valuation techniques for estimating WTP are:

• Revealed Preference – market prices and hedonic pricing; and

• Stated Preference Methods – contingent valuation and choice experiment.

The Revealed Preference technique infers or derives the value of non-market goods and services from market prices or market transactions. The Stated Preference methods ask people to directly or indirectly state their values in a hypothetical setting. Stated Preference valuation techniques are increasingly being used as means of establishing monetary values for impacts which do not themselves have observable monetary values. These have been extensively used in the field of transport, where it was first established, and it is now being used in a number of other public sector fields, such as environment, health, housing, leisure and education.

Stated Preference valuation techniques are mostly employed in eliciting customers’ WTP for a change in water service levels. These techniques construct demand functions for consumers through the use of surveys/questionnaires.

Contingent Valuation: In Contingent Valuation Methodology (CVM), consumers are asked to state their WTP for a specific package of improved water services. It is a useful methodology if there is a specific package for the consumer to consider. The most essential aspect of CVM is creating a realistic scenario, which has accurately priced water supply ’options’ that reflect the level or prices the water service provider would have to charge in order to provide the service. The respondent is asked about their preferences


and is effectively asked at what price they would be willing to ’buy’ the water, based on the level, quantity and quality of service. However, there are limitations to this approach because it relies on customers’ answers to direct questions on the subject; it is susceptible to considerable bias because of the tendency to encourage ‘tactical’ responses. There is a risk of consumers answering strategically, whereby respondents understate or overstate their valuation of the product or service in question. For example, respondents might suggest that they are unwilling (or unable) to pay anything more to discourage regulatory agencies or water companies from putting prices up. Various techniques have been developed to try and eliminate biased response. In particular, the way that the CVM scenario is presented to the respondents and how WTP questions are asked can be specifically designed to reduce bias.

Choice Experiment: In a Choice Experiment, a survey respondent is presented with two or more options for service levels and associated price and is asked to state which option he/she prefers. Thus respondents make a choice among a number of options each with defined attributes. A monetary value is included as one of the attributes so that when individuals make their choices, they implicitly make trade–offs between both the level of the attributes in the different alternatives along with the costs associated with each one. Different service levels and prices are specified in a number of experiments to provide the variation that is necessary for identifying an estimate of the marginal utilities of each attribute. A series of experiments is presented to each respondent, with the experiments varying over respondents. Respondents’ choices reveal their WTP (or otherwise) for improved service. Statistical analysis of the responses, using discrete choice models, provides estimates of the WTP.

Choice Experiment is the preferred method when searching for the value of individual attributes of a product or service. It is useful when information on relative values for different characteristics or attributes of a non-market good is needed, as compared with CV in which the number of scenarios that can be considered in one study is limited. Relevant aspects of water supply attributes (including issues such as water quality and reliability of water supply) to be included in each choice set is determined through a series of exploratory and qualitative focus group discussions. The information from the focus group will form the basis of designing the Choice Experiment, such as which service attributes to include in the experiment, how attributes are to be described and the levels that each attribute could take. Thus the initial focus group discussion helps in selecting relevant water supply attributes that matter most to end-users of the TECHNEAU schemes. The attribute levels should be realistic and span a range over which respondents can be expected to have preferences (Pearce et al, 2002). Attribute levels should include “without project” or the ‘status quo’ level and a range about the existing level in order to elicit WTP for a gain and WTP to avoid a loss. However, it is argued that there can be tendency for respondents to prefer the status quo over changes in service levels in either direction due to various factors such as risk aversion and/or disutility to change. To mitigate this, it is essential that attributes of each option are stated in absolute terms rather than relative to the respondents’ current situation (Hensher et al, 2004). Undertaking a WTP survey – Issues to consider The WTP survey sample should be representative of the region or area under consideration. Though the sample size depends on the population, there is usually a need for a sample size of at least 500 to 600 to ensure statistical validity of results. It is essential


to describe the criteria for choosing the sample. These criteria are defined by the objective and expected output of the survey. A typical survey questionnaire should have the following components: socio – economic characteristics of the respondents, awareness and perception of water quality issues, bill payment, etc., and choice sets for estimating the WTP for improved water quality. The inclusion of respondents’ socio – economic and demographic characteristics (e.g. sex, age, income, etc.) in choice modelling allows for the impact of different user characteristics on WTP to be assessed.

There are different methods available for performing the WTP interviews. The preferred method is by face-to-face interviews. However, this is the most costly and time-consuming, thus it is often more effective to use other methods, such as postal or telephone surveys. A combination of postal and follow-up face-to-face methods is very effective Carrying out a WTP survey can have significant time and costs implications. Cost and time elements depend on factors such as the method used to elicit customers’ WTP (whether CVM or choice experiment), number of field workers and consultancy team (cost of labour), sample size (number of households), time required to design questionnaires and train field workers, etc. Also it is much cheaper to administer WTP surveys in developing countries than in industrialised countries. Enumerators are relatively cheap; therefore the cost of surveys is normally considerably less than they would be in a developed country. In general, it is not possible to set out a blueprint for the amount of time and resources that are required for a WTP survey. This will depend on the size of the project area, the size of the random sample deemed necessary to gauge demand accurately, and whether the results are to be used to set tariff and subsidy (depending on the mode of water supply system) or just to provide useful information on preferred options and affordability. Benefit Transfer Another approach to estimating non – market benefits is the use of benefit transfer (BT). BT is used to estimate economic values by transferring available results from one study with similar impacts to the project being evaluated but completed in another location or context. It is often used when it is too expensive and/or there is too little time available to conduct an original valuation study, yet some measure of benefit is needed. In undertaking a BT approach, it is important to ensure that the service parameter being valued is comparable to the service parameter valued in the existing study. Also, the characteristics or demographics of the relevant population should be comparable. Although this approach satisfies time and budget constraints, it is important to note that it can only be as accurate as the initial study.

2.4.6 Discounting the future stream of costs and benefit All costs and benefits are to be evaluated at present values using an appropriate discount rate and planning horizon of the analysis. The choice of discount rate can have a significant effect on the evaluation of costs and benefits when the time horizon is long. This is based on the principle that a given amount of money is always more valuable


sooner than later, since this enables one to take advantage of investment opportunities. Thus more importance is placed on costs and benefits that occur now than those that arise in the future. When applied to monetary values, the discount rate should reflect the opportunity cost of capital or revenue. When applied to benefits, it is still appropriate to apply a discount rate since benefits are normally preferred now rather than in the future. However, care needs to be taken since a high discount rate can be contrary to a goal of sustainability. For example, using a discount rate of 6% would mean that environmental benefits of 100 units in Year 10 would have the same value as environmental benefits of 56 units today. However, changing the discount rate to 3.5% would mean environmental benefits of 100 units in Year 10 would be worth 71 units today. This seems a reasonable compromise between representing a preference for early benefits and not valuing future benefits too lowly. It is also important to make sure that the benefits in the future are sufficient to meet mandatory standards. A company’s cost of capital is usually the preferred rate for assessing the costs relevant to them. This is the private opportunity cost of capital and it is the rate of return on the most valuable alternative project given up. However when evaluating projects which have broad impacts on society, the capital market is not always the best arbiter on which to make such a decision. Higher discount rates normally result from using the private opportunity cost of capital which can “discount away” some of the long term environmental and social impacts or benefits of water project. The social discount rate is the preferred discount for such a case as it takes into account ethical consideration, i.e. all things being equal, society values its ability to consume in the future as highly as it values current consumption.

The number of years that a project should be discounted over depends on the policy proposal. A number of other factors should be taken into account:

• If the main cost is the purchase of a piece of equipment then the expected lifetime of that equipment could be used.

• If the costs or benefits are likely to appear well into the future, you might want to consider a longer timescale.

2.4.7 Decision Criteria – Net Present Value, Benefit Cost Ratio

Net Present Value (NPV) is a robust indicator of the financial (and economic) performance of a project. This measures the net benefit of a project, and it is estimated as the summation of the annual net benefit of a project over the period of analysis. In comparing mutually exclusive improvement options, the option that delivers the highest positive net present social benefit is selected. Assuming that the benefits are higher than the costs, then an overall benefit is achieved through implementation of the project. The net present value (NPV) is calculated as:

( ))(

11

1tt

T

tt CostsBenefits

rNPV −

+= ∑

=

Where


r = discount rate (%) t = time (years) One way of deciding which option is the most attractive is to choose the option with the highest benefit cost ratio (BCR). By placing monetary values on all benefits and costs, it is possible to rank the options dependent on their ratio of benefits to costs (i.e. the amount of benefits received for every pound spent). If the ratio is greater than 1, the benefits outweigh the costs and the project delivers net present social benefit. The benefit cost ratio is estimated as:

⎟⎟⎠

⎞⎜⎜⎝

⎛+

= ∑= t

tT

tt CostBenefit

rBCR

0 )1(1

Finally, it is often the case that all benefits accrue from the use of customer WTP. When this is the case, the average WTP for a change in the level of service can be compared with the marginal costs associated with the change. If the WTP exceeds the marginal cost then it is worthwhile.

2.4.8 Incorporating risks and uncertainty into a CBA Framework

A key step in a CBA is to identify and quantify all relevant costs and benefits as seen from the private and society’s viewpoint. The net present value (NPV) is then estimated as the sum of the discounted flows of costs and benefits over the presumed lifespan or timeframe of the project. Without accounting for risks and uncertainties, a NPV above 0 suggests that the project leads to a potential efficiency improvement as benefits exceed costs. Generally, all CBAs utilize variables which can only be assessed or forecasted imprecisely. The risk or uncertainty of the variables included in a CBA will affect the precision of the estimated expected NPV or any economic decision criteria such as the BCR. It is therefore imperative to consider the effects of risk and uncertainty when undertaking CBA. A “risk assessment” should be included in the analysis in order to deal with the uncertainty that always permeate investment projects. Two main steps should be undertaken: sensitivity analysis and risk analysis: • Sensitivity analysis Sensitivity analysis aims to identify the project’s critical variables and can therefore be used to assess the sensitivity of the expected NPV to changes in these variables. This is done by letting the project variables or parameters vary according to a given percentage change and observing the subsequent variations in both financial and economic performance indicators, i.e. the NPV and BCR. Parameters should be changed one at a time, while keeping all others constant. The calculation of the changing values can reveal interesting information, by indicating what percentage change in the variables would make the NPV (economic or financial) equal to zero. Sensitivity analysis can address two key questions:


• Would the proposal still be worthwhile pursuing if some of the key assumptions do not eventuate?

• Are there actions that can be taken to reduce the risks before accepting a particular option?

Sensitivity analysis can help in forecasting uncertainty and in assessing and treating project risks. A common approach is to test combinations of key variables in three scenarios: a pessimistic scenario, most probable or base scenario, and an optimistic scenario. Consequently this approach can be used to test the robustness of the analysis as well as allowing for uncertainty about future cash flows. • Risk analysis Assessing the impact of given percentage changes in a variable on the project’s performance indicators does not say anything about the probability with which this change may occur. Risk analysis deals with this. By assigning appropriate probability distributions to the critical variables, probability distributions for the financial and economic performance indicators can be estimated. This enables the analyst to provide statistics on the project’s performance indicators, e.g. expected values, standard deviation, coefficient of variation, etc. The first step in applying risk analysis to a CBA is to identify the key parameters whose variation have significant effects on the outcome: this can be done by sensitivity analysis. The probability distribution of each chosen parameter should then be estimated using methods ranging from sophisticated statistical analysis of past experience to educated guesses. The next step is to estimate the correlation between the chosen variables. Examples of correlated parameters are discount rate and net present value. The next step is to simulate the analysis or run the model a large number of times with the different values of the chosen parameter each time. For example, while the complete CBA calculation is carried out about 1000 times, determining and recording the NPV (or other indicator) each time. The final step is to present and interpret the results of the simulation. One or more output parameters, normally the CBA indicator such as the NPV or BCR, will have been recorded for each iteration, and the probability distribution of the output parameter’s values can be presented as a histogram, as a cumulative curve or as a table of descriptive numbers such as mean, standard deviation, quartiles, deciles and extremes. It should be noted that while it is always possible to do a sensitivity analysis, the same cannot be said for risk analysis. In some cases (e.g. lack of historical data on similar projects) it may prove rather difficult to come up with sensible assumptions on the critical variables’ probability distributions. In such cases, a qualitative risk assessment should be carried out to support the results of the sensitivity analysis.

2.5 Incorporating carbon footprint and Whole Life Costing in a CBA framework

The increasing focus on climate change will probably force water utilities to also include carbon footprint calculations in addition to costs of a project in the future. The carbon footprint is a measure of the total amount of carbon dioxide emissions that is directly and indirectly caused by an activity or is accumulated over the whole life of a product. The


total amount of CO2 emitted could be converted into a monetary equivalent and be included in the cost benefit framework of a project. In the UK, Ofwat is encouraging water companies to propose innovative solutions to mitigate their carbon footprint and emissions of other greenhouse gases. Companies are required to estimate and use the carbon dioxide equivalent (CO2e) of their investment options in their CBA. This will allow the company to balance local (quality) and global (carbon) issues ensuring the potential total impact on society and the environment (?), which is vital for decisions relating to sustainable development. There is a wide and expanding body of literature relating to the assessment of carbon emissions. Although there is not one standard methodology for carbon footprinting, there are a number of common elements which require inclusion, often being subdivided into those issues related to construction (construction traffic, equipment, embodied carbon), and those related to operational issues (energy and fuel consumption, traffic emissions and waste disposal)

Carbon footprints estimation is very much linked to whole life costs of an asset or intervention. Thus, the whole life cost of an asset or a technology to improve water quality need to be undertaken in order to quantify the lifetime environmental impacts (in terms of CO2 emissions).

Two main stages are involved in estimating the impact of CO2e. Firstly, the emissions of commissioning, operating and maintaining the assets over the whole life should be estimated. This involves the conversion of both carbon and other greenhouse gas emissions into their CO2e. These estimates can then be converted into monetary valuations. In the UK, the Department for Environment and Rural Affairs (DEFRA) has proposed the Shadow Price of Carbon (SPC) methodology that allows the emissions to be measured and valued1. The Shadow Price of Carbon (SPC) is used to value the expected increase or decrease in emissions of greenhouse gases resulting from a proposed policy. It therefore reflects the damage costs of climate change caused by each additional tonne of greenhouse gas emitted – converted into carbon dioxide equivalent (CO2e) for ease of comparison. The annual quantity of greenhouse gas emitted (expressed in CO2e) is multiplied by that year’s SPC to derive the monetary equivalent of the carbon impact of the project. These monetised greenhouse gas values are used in a CBA. This includes showing the NPV of the carbon impacts in isolation and as part of the overall NPV.

The incentive to incorporate carbon footprints in CBA depends on the regulation and legislation in each country, but can in many cases be worthwhile due to pure economic aspects, e.g. reduced CO2 emissions as a result of reduced energy consumption will also reduce costs. The CBA will balance and optimise the benefits from reductions with the corresponding costs.

1 How to use the Shadow Price of Carbon in policy appraisal. http://www.defra.gov.uk/environment/climatechange/research/carboncost/pdf/HowtouseSPC.pdf


2.6 Case Study: Using CBA to measure the net benefits of water quality improvement

Cho and Kim (2004) estimated the monetary value of water quality improvement from ‘3rd Class’ to ‘1st Class’ in the Paldang Reservoir using the Contingent Valuation Method (CVM) to measure individuals’ willingness-to-pay (WTP). A questionnaire survey investigated improvements in the water quality of the Paldang Reservoir and analysed what factors influenced respondents’ WTP. The estimated individual WTP was used to calculate the total WTP of the community affected, and this was then compared with the compliance costs of proposed regulations to the polluting sources. Various regulatory options by local and central government to improve the water quality of the Paldang Reservoir and their costs to prevent degradation were analysed. Finally, the costs and benefits associated with each option were compared and the most cost-effective regulatory option to improve the reservoir was identified based on CBA. This study focused mainly on the economic costs and benefits to households of water quality improvement. Information on benefits and costs will help policymakers find the socially optimal level of abatement of water contamination in Korea. The household survey was designed to collect information on socio-economic characteristics of the respondents, their WTP for improving the quality of the drinking water, their awareness and perception of the water quality of the Paldang Reservoir, types of water source and use, and their monthly water bill. A personal interview provided specific information about the quality in the reservoir and respondents were asked to select, from a set of predetermined values, the most they would be willing to pay. The respondents were also asked to provide their perceptions about the water quality in the reservoir, their type of drinking water, monthly water bill, and other socio-economic characteristics. Results of the survey showed that socio-economic characteristics such as gender, age and income had significant effects on respondents’ WTP. Gender had a negative and significant effect on WTP for improving the water quality: a male respondent was on average willing to pay more to improve the water quality. The number of years that respondents had resided at their current address also had a negative and significant effect on WTP: if the respondent had resided longer at the address, the less he/she was willing to pay to improve water quality. Both income and the current water bill had positive and significant effects on WTP: if the respondent had more income and paid higher water bills, then he/she was willing to pay more to improve the water quality. However, age and household size did not show significant effects on WTP. The average WTP, based on the predicted value from the estimated WTP function in this study, was 1,860 Won2. This average WTP was multiplied by the total number of households in the Seoul metropolitan area supplied by the Paldang Reservoir to calculate an annual aggregate WTP to improve water quality. The annual aggregate WTP was estimated at 1,292 billion Won - a little over $1 billion. The Government of Korea developed the plan to improve the water quality of the Paldang Reservoir from ‘3rd Class’ to ‘1st Class’ water by the end of the year 2005. The plan included building more wastewater treatment facilities and updating existing facilities to

2 Currency of South Korea: 1 US$ = 934.939 Won


further control liquid waste from manufacturing industry and wastewater from livestock farming in the region. The cashflow of the project was 12 billion Won in 1999; 1,877 billion Won in 2000; 2,475 billion Won in 2001; 2,348 billion Won in 2002; 2,679 billion Won in 2003; 2,966 billion Won in 2004; and 2,966 billion Won in 2005. Assuming that the life span of the new investment was 20 years, calculated net benefits (2005 basis) associated with 4%, 5%, 6%, 7%, and 8% discount rates, respectively, are shown in Table 5. Table 5 Net benefits for improving the water quality of the Paldang Reservoir (in million Won) Discount Rate Cost (Won) Benefit (Won) Net Benefit (Won)

0.04 1,678,538 2,060,397 381,859 0.05 1,717,384 1,965,029 247,645 0.06 1,757,198 1,880,539 123,340 0.07 1,798,001 1,805,634 107,633 0.08 1,839,813 1,739,199 100,613 The aggregate WTP for improving the water quality of Paldang Reservoir was estimated higher than the cost for all ranges of discount rates considered in this study. This implies that it is profitable to undertake the project as the net benefit is high even with increasing discount rate.

2.7 Discussion

A general assessment of operation and maintenance of drinking water systems considers • External conditions, such as legislation • Local target levels, e.g. aim of service reliability • Cost-benefit analysis of concrete projects or actions.

This report handles the CBA specifically, whereas the external conditions and target levels are site-specific and will be subject to discussion related to case studies. As stated earlier, the aim of this work area is to develop a methodology or a framework to assess the net benefits of new technologies and results developed in TECHNEAU. This will provide a basis for justifying any capital investment to improve water quality at the various end-user sites. This framework will therefore assist in evaluating the costs and benefits of a technique, as well as incorporating risks and assessing benefits using customer surveys. The main goal is therefore to use the framework developed (as discussed above) to analyse cost and benefits of new technologies from TECHNEAU WA5. End-users in TECHNEAU WA5 can be used as case studies for 2-3 different technologies. These case studies will provide an illustrative guideline as to how the CBA framework developed can be used for improvement technologies and incorporating results from TECHNEAU. It is recognised that the application of CBA will be different for different end-users. The CBA tool is therefore developed to fit different users and not to be technology specific.


There is also the issue of how benefits of an improvement should be measured. Generally, people’s valuation of goods is seen by the amount of money they are willing to pay for the service/product in the market. However there are no market values for benefits of water quality improvements as these have no market values. Therefore reliably estimated monetary values for non-marketed goods will reflect people’s willingness to pay for (or accept) certain changes. This necessitates the use of economic valuation tools that measure WTP for improvements in water quality. However, the use of a WTP study in a CBA has raised questions about its practicability and suitability for the different end-users. It has been argued that these valuation techniques could have a tendency to undervalue costs and benefits to be experienced by future generations. There is also often high uncertainty surrounding valuations made by consumers. Furthermore, there are many moral questions surrounding monetizing human health, human lives and the social and environmental impacts of a project. It is also recognised that a WTP survey can have significant time and costs implications. In spite of these challenges, it is recognised that a WTP study provides a robust means of assessing intangible or non-market benefits associated with water quality improvement. However, methods of undertaking the WTP study will be different for different end-users due to differences in operation, regulation and organizational responsibilities of the water service providers.

2.8 Conclusions

This report has set out a methodology or framework for undertaking a CBA of implementing technologies from TECHNEAU. CBA seeks to provide the information necessary (in terms of costs and benefits) to evaluate the profitability of implementing technology to improve water quality. While carrying out a CBA requires time and effort, the information gained from a good quality CBA can provide significant pay-backs by improving the decision making process. However, there are a number of challenges in undertaking any CBA (a number of which have been discussed in the preceding sections), including: • Identification of all the relevant costs and benefits - It is not always easy to know each

and every effect a project may have. If each impact is not recognised until the project is undertaken, the pre-implementation analysis will have miscalculated the expected costs and/or benefits.

• Double counting costs or benefits - Sometimes the impact of a project can be measured in two or more ways. In such a case, there is a possibility to “double count” when identifying and deriving estimates for costs and benefits of the project. Also, there could be double counting of altruistic values. This occurs when respondents of a WTP survey assign monetary values on behalf of others (in their household or wider community) as well as themselves and the values are then expanded from the sample to the population.

• Measuring the size of the costs and benefits even where these do not have an easily identified market price.


Despite these challenges, it is acknowledged that a correct application of CBA – with appropriate sensitivity analyses to evaluate the potential effects of key uncertainties - is a valuable tool in the decision making process on complex issues. This is because CBA considers gains and losses to all members of the community who are affected by the project being considered. It includes all benefits and all costs, including both tangible and intangible, as well as both internal and external. It does not concentrate solely on the financial implications. Also, because it values impacts in terms of a single common unit, it is easy to compare competing projects once the CBA has been performed.


3 REFERENCES

Hensher, D Shore, N and Train, K (2005). Households’ Willingness to Pay for Water Service Attributes, Environmental and Resource Economics, Volume 32, Number 4, pp 509 – 531. Kim, H J and Cho, Y (2004). The Cost-Benefit Analysis of Improvements of Water Quality of the Paldang Reservoir. Ofwat (2006). Developing our Process for Assessing Capital Maintenance Requirement. Consultation Paper RD04/06. Pearce, D et al. (2002). Economic Valuation with Stated Preference Techniques: Summary Guide. Department for Transport, Local Government and the Regions, London. Smith, A (2005). Capital Maintenance: A Good Practice Guide. Water Asset Management International, 1.1, 15 – 21. UK Water Industry Research UKWIR (2006). The Role and Application of Cost Benefit Analysis. Generic Guidance Version (Unpublished) Wegwood A Sansom K (2003). Willingness-To-Pay surveys – A Streamlined Approach. Guidance notes for small town water services. Water Engineering and Development Centre, Loughborough University. Wiedmann, T. and Minx, J. (2007) A definition of Carbon Footprint ISA UK Reseach Report 07-01 http://www.carbontrust.co.uk/publications/publicationdetail.htm?productid=CTV033)


http://www.carbontrust.co.uk/publications/publicationdetail.htm?productid=CTV033

D 5.1.2 Framework for cost benefit analysis - · PDF fileColofon Title FRAMEWORK FOR...

Documents

Transcript of D 5.1.2 Framework for cost benefit analysis - · PDF fileColofon Title FRAMEWORK FOR...