THE WORLD BANK

Internal Discussion Paper

SOUTH ASIA REGION

Report1 o. IDP-126

Some Guidelines for the Appraisalof Large Projects

William JackFebruary 1993

Office of Chief Economist SASVPMICROFICHE COPY

Report No.: I0P- 126 SAS Type: (IDP)Title: SOME GUIDELINES FOR THE APPRAIEAuthor: ESTACHE, A.Ext.:81442 Room:E10081 Dept.:SASVP

The views presented here are those of the author, and they should not be interpreted as reflecting those of the World Bank.

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SOUTH ASIA REGIONAL SERIES

]]tle Author 2ft Oriainator

IDP111 How Composition of Public ExpenditureAffects Competitiveness: The Case ofBangladesh K. Matin March 1992 P. Mitre (80419)

IDPI 21 Labor Retrenchment and RedundancyCompensation in State Owned Enterprises:The Case of Sri Lanka A. Flsabein December 1992 G. Nankant (84841)

IDP126 Some Guidelines for the Appraisal ofLarge Projects W. Jack February 1992 A. Estache (81442)

ASIA REGION DISCUSSION PAPERS 1/

T]il Autho.t 21at Oriainator

IDP2 The Labor Force Participation of WomenIn the Republic of Korea: Evolutionand Policy Issues C. Grootaert May 1988 F. lqbal

IDP15 The Role of Exchange Rate Policy In FourEast Asian Countries S-W. Nam May 1988 D. Lelpaiger (81388)

1DP28 The Small*Scale Enterprise Credit Program(S.S.E.P.) Under the Second and ThirdCaloutta Urban Development Projects(CUDP II and CUDP II) - An Assessment F. Kahnert March 1988 F. Kahnert (81413)

IDP35 Improving Tax Policy Advice: Lessons andUnresolved Issues from Asia Experience H. Flelsig June 1989 H. Fielsig (81413)

1DP36 Direct Taxes and Fiscal Policy Issues:An Illustration for East Asia A. Virrnani June 1989 H. Fielsig (81413)

IDP37 Commodity Taxation in Selected CountriesIn South East and East Asia Z. Shalilzi June 1989 H. Flelsig (81413)

IDP38 Tax Analysis In Developing Country Settings R. Muagrave June 1989 H. Flielsig (81413)

IDP39 Indonesia: External Shocks, PolicyResponse and Adjustment Performance S. Ahmed June 1989 S. Ahmed (82467)

11 Papers still available upon request. Asia Series discontinued following December 1, 1991 restructuring of the Region.

Note: Extra copies may be obtained from the Asia Information Service Center.

SOME GUIDELINES FOR THE APPRAISAL OF LARGE PROJECTS

William Jack*

December 1992

Acknowledgements: Thanks to John Besant-Jones, Antonio Estache, Heywood Fleisig,Pradeep Mitra, Gobind Nankani, Joanne Salop, Hisanobu Shishido, Anandarup Ray, W.Teplitz-Sembitzky, and many other World Bank staff for discussions and suggestions, and toIfediora Amobi for research assistance. Any errors are the author's.

*Prepared while a consultant to SASVP, the World Bank. Currently Economist, JointCommittee on Taxation, United States Congress.

SOME GUIDELINES FOR THE APPRAISAL OF LARGE PROJECTS

William Jack

Abstract

The paper examines possible modifications to standard techniques of cost-benefit analysisas employed by the World Bank in the appraisal of large projects. The identification of the mainissues raised by standard practice is based largely on a review of a sample of Bank appraisalsof large projects. The paper identifies three areas in which current methods may be improvedin practice, including the measurement of benefits, the treatment of uncertainty, and the handlingof macroeconomic impacts and constraints. Within each of these three areas, we ask: (i) whatis done presently?, (ii) what are the shortcomings?, and (iii) how can the methodology beimproved?

* Standard Practice: small project techniques value benefits from output expansion asa shadow price times the change in quantity. Other estimates of benefits include the next bestalternative cost of supply, and various financial revenue measures.

* Shortfalls of Standard Practice: in general, large projects cause prices of non-tradables(and sometimes tradables) to change, so shadow revenue estimates of benefits (shadow pricetimes quantity) based on marginal analysis may be inappropriate. Also, alternative cost andfinancial revenue may bear little resemblance to true benefits.

* Improvements in practice for large projectso If prices change, estimate pre- and post-project shadow prices. These can be used

to implement a "first stage" appraisal, derived from a non-exhaustive set of sufficient conditionsfor acceptance or rejection of the project.

o If the first stage appraisal is inconclusive, consumer surplus measures should becalculated for goods whose prices change. This requirms information about the demand curve,not point estimates.

o The income effect can be incorporated if the income elasticity of demand for agood is high.

o The income effect will be relatively more significant if output is allocated byflexible prices than if it is rationed by non-market means.

o The distribution of net benefits should be considered carefully in large projectappraisal, since potential gains and losses are significant, and the size of the population affectedmay make it hard to identify and compensate the losers.

(ii)

Uncertainty

* Standard Practice: in general risk is not explicitly accounted for in project evaluations.This is usually (but not always) sound practice for small project appraisal. Sensitivity analysisis often not particularly instructive.

* Shortfalls of Standard Practice: risks associated with large projects cannot easily bediversified. Also, many of the Bank's large projects, such as irrigation and transport systems,may be correlated with national income, increasing overall risk. In addition, large projectsrepresent a large commitment of resources; in making such a commitment, the country foregoesthe option of changing its plans when future uncertainties are resolved. This represents a realcost which is often not included in appraisal.

* Improvements in practice for large projectso At the very least, expected values for variables should be used ahead of modal

values, irrespective of the size of the project.o For large projects, calculating certainty equivalents is more reliable than adjusting

the interest rate to account for risk. In general, comparison of the expected internal rate ofreturn with a standard risk-adjusted interest rate will be misleading.

o When projecte are irreversible, the option value associated with the investmentneeds to be incorporated into the appraisal. This can affect the timing of the investment, thetechnology chosen, and the sequencing nature of a large development.

o In general, even if risk can be diversified, irreversibility will mean that expectedrates of return should be higher than the risk-free interest rate.

Macroeconomic ImpAc

* Standard Practice: the fiscal and intersectoral macroeconomic impacts of the projectmay not be directly (nor even tangentially) considered at the appraisal stage.

* Shortfalls of Standard Practice: the resources required to finance a large project mayseriously impact upon the government's budget. If budgetary problems are already severe, theconsequences for general growth and human development must be recognized at an early stage.

* Improvements in practice for large projectso Analysis of the fiscal position of the government must be conducted to investigate

the feasibility of a large project. In particular, savings and foreign exchange constraints mustbe shown to be non-binding, perhaps as a result of complementary macro or microeconomicpolicy reforms. Real exchange rate movements induced by the project should be included inanalyses of debt sustainability.

o If sufficient resources can be mobilized to finance a large project, the desirabilityof doing so should be addressed. This can be done by the use of shadow prices for publicfunds, recalling that large amounts of extra taxes or reduced social expenditures may involvehigh social costs.

0 Finally, sectoral issues should be addressed. If a large project is similar to anexternal shock, then the macroeconomic impact may require accommodating fiscal and monetarypolicies. This said, it is argued that many large Bank projects do not have the samecharacteristics as orthodox Dutch Disease models.

Policy Implications. Incorporating the suggestions of the paper for improvements intoproject appraisal will mean that some previously rejected projects will now be accepted, and viceversa. It is difficult to tell in which direction the effect will be due to changes in themeasurement of benefits, since current methods can yield both under- and over-estimates. Onthe other hand, proper integration of risk analysis and option values is very likely to lead tofewer large projects being accepted, except when project output is negatively correlated withnational income (in which case good risk analysis would show the project to be more sociallybeneficial than otherwise). Accurately accounting for macroeconomic impacts and fiscalrequirements also appears to favor the acceptance of fewer large projects than otherwise.

Table of Contents

1. Introduction .............. ..... 1

2. Estimating Benefits of Large Projects ........................ 5

(I) Shadow Pricing Techniques and First Stage Appraisals .......... 6

(II) Explicit Benefit Estimation - Market Clearing Prices ........... 7

(a) NoIncomeEffects ......................... 7

(b) IncomeEffects ............................... 9

(III) Explicit Benefit Estimation - Non-Clearing Markets . .......... 10

(a) Some Bank Estimates ........................... 11

(i) Least Alternative Cost ........................ 11

(ii) Revenue Measures .......................... 12

(IV) DistributionIssues ................................ 14

(V) PolicyDiscussion ................................ 15

(a) WhentoIncludetheIncomeEffect ................... 15

(b) Identifying Projects Where Income Effects are Important ..... 15

(VI) Further Income-Related Issues in Benefit Estimation ........... 17

(VII) Summary ..................................... 18

3. Uncertainty, Risk, and Project Design ........................ 20

(I) Accounting for Risk in Project Appraisal ............ ....... 20

(a) Expected and Modal Values . . . . . . . . . .. . . . . . . . . . . .21

(b) RiskAdjustments .............................. 21

(i) Certainty Equivalents ........................ 22

(ii) Risk Adjusted Interest Rates .tes4. ............ . 23

(iii) DistributionofRisks ........................ 24

(iv) Comment on the Capital Asset Pricing Model ......... 24

(II) Project Design Under Uncertainty and the Value of Flexibility ..... 24

(a) Robust Planning and Multi-Objective Programming ......... 25

(v)

(b) Option Values ................................ 27

(i) TheTimingofInvestment ..................... 27

(ii) Choice ofTechnology .............. . 30

(iii) Small Versus Large Projects ................... 31

(III) Summary ..................................... 31

4. Macroeconomic Issues .................................. 34

(1) Introduction .................................... 34

(II) Macroeconomic Feasibility . . . . . .... . . . . . . .. . ... . . 35

(a) Affordability Constratins and Financing Gaps ............. 35

(b) Complementary Macroeconomic Policies . . . . 36

(c) MacroeconomicReform .......................... 37

(d) Some Implications for Appraisal ..................... 38

(e) Debt Sustainability and Real Exchange Rate Movements ...... 38

(III) Macroeconomic Desirability ................ . . . . 40

(a) Rasing Extra Revenue ........................... 41

(b) Expenditure Reductions .......................... 41

(IV) SectoralIssues ................................... 43

(a) Is Dutch Disease a Problem? ....................... 43

(b) Do Sectoral Imbalances Matter for World Bank Projects? ..... 43

(V) Summary ..................................... 44

5. FinalRemarks ..................................... 47

Some Suggestions for the Extension of the Appraisal of Arun III .... 49

Bibliography ......................... ............ 51

Appendices ..................................... 54

SOME GUIDLINES FOR APPRAISAL OF LARGE PROJECTS

1. Introduction

This paper aims to identify modifications to standard techniques of cost-benefit analysisemployed by the World Bank in the appraisal of large projects.' It draws on a range oftheoretical and operational material to present some recommendations on "best practice"approaches to project selection and design. The paper offers general guidelines describing theconditions under which the largeness of projects is important, and those under which themethods of small project appraisal are sufficient for making economically rational investmentdecisions.

The first issue to deal with is one of definition: When should a project be consideredlarge? We answer this question indirectly by identifying three broad categories of effects whichcan be important in themselves, and are more likely to occur with large projects:

(i) changes in market and shadow prices;(ii) the bearing of non-diversifiable risk, and the foregoing offlexibility; and(iii) macro-economic impacts, on investment, savings, debt, etc.

This list of effects is obviously not a strict definition of a large project, but given that we areinterested in large projects because of their consequences, it is a sufficient means of fixing ideas.

Bengfits. The first category includes familiar demand and supply responses to pricechanges and induced income effects. When the net supply of the project good changes by alarge amount its price and that of other goods may do so also. Benefits must then be calculatedusing some kind of consumer surplus measure.? However, a "first stage" appraisal can beundertaken using orthodox shadow pricing techniques without resorting to detailed benefitcalculations. If this is inconclusive consumer surplus measures must be investigated. It is wellknown that standard measures must be corrected for the income effect; it is argued that whenoutput is not allocated by flexible market prices, this may not be important in calculating netbenefits. A number of approaches used in Bank appraisals are considered, and compared withtheoretically more accurate measures.

Note that just as market prices change when projects are large, so too do shadow prices.In fact, it is possible that the market price of labor, say, remains constant even with a large

1\ The identification of the issues is based on a review of standard practice in a sample of large Bank projectsand on discussions with Bank economists directly or indirectly involved in some of these projects. Appendix 4provides an overview of the characteristics of the projects reviewed.

Z\ This requires knowledge of the demand curve for a range of prices. When the project is small and theproject good's price does not change, the value of demand at that price is all that is necessary to calculateadditional benefits.

2

project, but that the shadow wage rate changes significantly. Using shadow prices, while stillnecessary, does not allow the analyst to treat them as fixed. Only when the goods areinternationally tradable at fixed world prices do shadow prices remain constant; but the outputsof many large projects are non-tradable.

Risk. The second category derives from uncertainty about future cost and benefitconditions. The debate surrounding risk adjustments in public project appraisal has been longand controversial, and we examine the situations under which such modifications should bemade. However, even when the government is risk neutral, so that risk premia are clearly notnecessary, future uncertainty matters when projects are irreversible. This issue, which hasnothing to do with risk, is independent of the size of the project, but it is noted that largeprojects are more likely to entail significant sunk costs - i.e. irreversibilities - than small ones.

M1acroeconomic Implications. Finally, the effects of the project on macroeconomicvariables may be significant. The government's budget position could be affected in many cases,especially when cofinancing requirements are present. The revenue raising capacity of thegovernment is then important, and the concept of fiscal affordability relevant for project choice.In a dynamic context, a related issue is the capacity of the economy to sustain increased debtburdens associated with large project loans. The impact of the project on domestic savings andinvestment, and on future foreign capital flows, is crucial in this respect. Similarly, fiscal andmonetary policy responses to induced conditions of macroecm.omic disequilibrium are examined;such policy responses may be necessary if domestic factor markets exhibit rigidities, and theproject acts like an external shock.

This last remark illustrates that large projects may often need to be accompanied bycomplementary policy reforms or responses. This places a burden on the analyst to consider thepolitical feasibility of such reforms, and to be realistic about their chances of implementation.

It is worth noting the similarities between the third and first impacts mentioned above.Macroeconomic effects such as savings and investment behavior, real appreciation, transitionalunemployment, and possibly inflation, occur either because relative prices change, or becausethey need to but cannot do so immediately. Similarly, general equilibrium effects in normalgoods markets are important when relative prices change. These two impacts could in principlebe combined, with no special discussion of the macroeconomy. However, it is useful todistinguish general equilibrium effects in some factor (especially labor) and money markets,which may not operate in a market clearing fashion.?

Finally, a significant source of problems in the construction and operation of large projectsis insufficient institutional capacity. These problems are usually manifest in delays at theconstruction stage, and under or inefficient utilization at the operating stage. The extent towhich these phenomena are proportionately more problematic for large projects than for smallis debatable, and relies on the structure of management incentives, integrated government

J\ It is noted that the other main macroeconomic effect - that on the governments budget position - is not quiteas easily included in the framework of relative price changes.

3

planning, and the perceived suitability of the project to local needs and wants. This issue willnot be explored in detail, but it is recommended that the likelihood of institutional constraintson project performance be explicitly included in the appraisal process.

In the next three sections we discuss the issues described above in categories (i) - (iii) .Section 5 offers conclusions and recommendations for best practice approaches to the socialevaluation of large projects. Two appendices give details of arguments and calculations omittedfrom the main text, and a third describes the Bank projects used in the text for illustrativepurposes.

Finally, as a summary of the recommendations to be offered in this paper, a schematicflow chart is presented below, illustrating the decision process for project analysts whenevaluating large projects.

FIGURE 1 FLOW CHART

NoIs the project Use standard

large? techniques

Yes

NoDo prices Are there important Are future benefitschange? macroeconomic andfor costs uncertain?

effects?---YesYesYes Yes Yes Yes Yes

Conduct "first 1No stage" analysis

Does thisproduce ambi-guous results?

No NoYes

Calculate net Is the project Are the How do inter- Make risk Use optionbenefits affordable necessary sectoral adjust- adjustments values toaccounting given the financing ments affect for large account forfor behavioral government's provisions the value of undiversible foregonechanges and budget desirable? the project? projects flexibilityincome effects position?

SAR

5

2. Estimating benefits of large projects

A project which changes the net supply of a good or group of goods by a significantamount may cause market and/or shadow prices to change. In the analysis of small projects,the value of an incremental change in the net supply of a good is equal to its shadow price timesthe change in quantity. When prices change as a result of the project, standard shadow pricingtechniques of project evaluation must be modified. One approach is to estimate gross benefitsfrom the project using consumer surplus measures, and to net out project costs. This isdiscussed in detail in the second part of this section. A less accurate, but also less data intensiveappraoch is to apply orthodox techniques to the project using both before- and after-projectshadow prices. This gives a rough guide to the desirability of the project, and can show theanalyst when a more detailed estimate of benefits is required.

When output is rationed by price - i.e. the market for the output clears - and there are notaxes or other distortions in the economy, market and shadow prices coincide. The observedor predicted market prices can then be used to calculate consumer surplus measures of benefits.It will be shown how, if the project affects gross consumer incomes, the standard surplusmeasure can be corrected for the income effect. It is argued that this effect will be importantonly if income elasticities of demand are large, and if any direct income increases due to theproject, stemming, say, from extra induced production, are relatively small. Ignoring the effectwill then lead to an over-estimate of benefits.

When consumer prices do not change to clear the market, estimates of shadow prices mustbe made. The adaptation of the techniques of the market clearing case for valuing benefits isthen satisfactory, but correcting for income effects is usually not necessary. A number ofalternative benefits estimntes have been employed by the Bank, including the cost of the nextbest alternative technology, and revenue generated at either pre-project prices or "reformed"prices. It will be shown that the alternauve cost and revenue at pre-project prices methods caneither under- or over-estimate benefits, while the revenue at reformed prices is typicallyconservative - assuming the reformed price clears the market.

It is recognized that some methods for estimating benefits are more data intensive thanothers. In fact, data limitations are the main determinant of the method chosen. Withoutknowledge of price and income elasticities of demand and general equilibrium effects it is hardto predict after-project shadow prices. However, it will be seen that some crude benefitsestimates used in Bank appraisals can only be justified by assuming some (incomplete)knowledge of demand characteristics. If such information is actually available, it is usuallypossible to make better estimates. Of course, for internationally tradable goods in a small openeconomy, shadow prices will not usually change, so the problems addressed here do not arise.On the other hand, many large Bank projects produce non-tradables in the form of irrigation,water, electricity, transportation, etc.4

.\ This is the main motivation for concentrating on the benefits side of the of the cost-benefit discussion. Inputsare considered to be either tradable, so their shadow price is constant (except under extreme circumstances), ornon-tradable and of abundant supply (e.g. unskilled labor).

6

(I) Shadow pricing techniques and first stage appraisals

Shadow prices tell us about the marginal opportunity costs of inputs and the marginalbenefits of consumed outputs. If it is assumed that marginal opportunity costs increase (or stayconstant, as in the case of many imported inputs) as the level of input use increases, and thatthe marginal benefits of outputs decrease as production inceases, then the net marginal benefitsof a project will necessarily decrease with output.' Under these assumptions, it can then beshown that the profit of the project, evaluated at pre-project shadow prices, is at least as largeas the net benefit. Simi arly, the profit at after-project shadow prices can be no larger than theactual net benefit.' This observation leads us to the following conditions for project acceptanceor rejection: 7

A sfficient condition to reject a large project is that project profits at pre-project shadowprices are negative; and

A sqfficient condition to accept a large project is that project profits at post-project shadowprices are positive.Clearly these conditions are not exhaustive, in that there will be some projects which havepositive profit at pre-project shadow prices which should nonetheless be rejected, and others thatmake a loss at post-project shadow prices which should be accepted. If the evaluation descibedabove is inconclusive in such a way, then the more detailed explicit benefit calculation describedbelow should be undertaken.

The main task of the project analyst in operationalizing this methodology is to calculatethe relevant shadow prices. To this end, the standard approximations of Little and Mirrlees(1974) are taken to be appropriate - namely, for traded goods, shadow prices are approximatedby border prices net of trade and transportation adjustments, while for non-traded goods, theyare calculated as the unit shadow cost of the primary factors and traded goods used in theproduction of the non-traded good in question.

The substantive difference with respect to small project appraisal at this stage of theanalysis is the estimation of post-project shadow prices. In particular, the consequences of theproject for shadow factor prices, specifically the shadow wage and accounting rate of interest,need to be assessed. As a first guess, one would expect that these two factor shadow priceswould increase if the project were large enough.

As mentioned above, this approach is not exhaustive, and can lead to inconclusive results.However, the shadow price calculations are not without further use, since they are required in

I That is to say, if V(z) is social welfare as a function of a project characterized by a variable z , then V isincreasing and concave.

f\ In terms of the welfare function in the previous footnote, if zo and z, represent the relevant variablesbefore and after the project respectively, then the net benefit of the project is V(71) - V(r;) . If pre- and post-project shadow prices are s and s, respectively, then so.(z, - r) a V(z) - V(re) Z sl.(z - re *

2\ These rules are simplified versions of those developed by Harris (1978), who assumes a non-convexproduction technology.

7

the more detailed estimation of benefits (discussed below), and can be used for future smallprojects undertaken after the large project is in place.

(U) Explicit benefit estimation - market clearing prices.

Market clearing prices give information about marginal benefits of consumption, whenthere are no other distortions. To calculate total benefits associated with a price change, thesemarginal benefits must be aggregated. The simplest kind of aggregation is the standardconsumer surplus measure, illustrated in (a) below. The inclusion of the income effect, to bediscussed in (b) below, requires information about income elasticities of demand.

(a) No income effects

We assume initially the existence of a representative consumer, so the government can useother policy tools to modify the distribution of income as it pleases. If demand for a good isdownward sloping and its supply increases, the market price falls. Assuming no income effects,the increase in gross consumer benefits from the consumption of the good is the area beneaththe demand curve as shown by area A + B in Figure 1. The change in net consumer benefitsdepends on the nature of the project and how the output is allocated. If the effect of the projectis to reduce the cost of producing all output, the net benefit is B + C , assuming the marketclearing prices po and p' are the long run average costs of production before and after theproject. Thus the (social) cost of producing the initial output is reduced by C = q4pl - powhile an additional cost of production (q' - qo).pl - A is incurred. The difference betweengross benefits and costs is then (A+B) - (A-C) = B+C . On the other hand, if the projectadds to the supply of output, but does not displace any pre-existing (higher cost) production, thenet social benefit is B . This second type of outcome is descriptive of power projects wherenew capacity is added. To minimize confusion, we examine methods for the calculation of grossbenefits - i.e. the area under the demand curve.

As well as changing outputs of consumer goods directly, large projects may inducechanges in other markets, depending on the linkages between the project good and otherproduction sectors in the economy. For example, additional electricity generating capacity willdirectly benefit consumers, but may also be a significant input into other production processes.A complete analysis of these linkages would require a general equilibrium estimation of theinduced changes in the costs of production, and consumer prices, of all final consumption goods.In general, we would expect the outputs of a number of consumption goods to increase. Theincrease in total benefits could then be estimated by aggregating the benefits from each goodcalculated separately. This method would require use of computable general equilibrium (CGE)models, which can be costly to develop and calibrate, and could retard the appraisal stageconsiderably. However, as a first approximation, it may be sufficient to use an aggregatedemand function for the project good(s) under consideration, instead of explicitly calculatinggeneral equilibrium effects. Applying the methods described below to such aggregate measuresshould then give reasonable results. The total increase in gross benefits from an expansion inoutput Aq is then given by

8

Be = pt.Aq-!Ap.Aq (1)2

This measure is accurate as long as the income elasticity of demand for the good inquestion is close to zero. As noted above, a full analysis of the economy-wide effects of a largeproject would require calculating the effects of the project on the prices of all final consumptiongoods. In fact, the formula in equation (1) applies even when the prices of many goods change,in which case p , Ap , and Aq are vectors. In practice however, the problem is to estimateall of these price changes, and the associated quantity changes. Here, we interpret the goodsin equation (1) as the project goods alone, with the quantity changes including additionalconsumer and producer demands.

pO

CBpl

A

qO qi

Figure 1

There is sometimes confusion as to which increases in incomes should be included asbenefits in project appraisal. Starrett (1988), for instance, suggests that

"Perhaps the single most important and useful guideline tells us to ignore all activityon secondary competitive markets."'

However, this statement is with respect to small projects. He uses the example of a smallirrigation project increasing the demand for tractors, and asks whether the additional profits to

I\ Stanfett (1988), page 158.

9

tractor suppliers should be counted as benefits. Since the tractor suppliers are competitive, thesmall increase in demand will be sold at marginal cost, including the cost of capital. Thus anyprofit earned on the additional sales covers the cost of capital, and there is no net increase inincome.

On the other hand, if the irrigation project is large, so that demand increases enough tochange the price of tractors, extra profit is earned on all inframarginal units, and this pure profitwould have to be included in the benefit calculation. In fact, Starrett goes on to say that if theproject has any direct effects on production possibilities in other markets, these should becounted.

(b) Income effects

Bank investment projects are designed to generate income.' This is presumably intendedto have an impact on the consumption patterns of those whose incomes are affected, so assumingzero income elasticities of demand for all goods would not be consistent with the original intent.However, as mentioned above, equation (1) is only valid when the income elasticities of demandfor the goods whose prices change are zero. When these elasticities are non-zero, the effect ofthe project on real income through both production expansion and price changes must beconsidered. Adapting the work of Hammond (1983), equation (1) is then modified to read

Bi = p1.Aq-1Ap.Aq+!(Ap.bo)Am (2)2 2

where be is the vector of income responses of demand,"o and Am is the change in realincome. This real income term depends on the effect of the project on the price of existingoutput: if the price for all output falls to p1 , then Am = -Ap.qo , since the representativeconsumer now saves Ap.qo on its original purchases (since Ap < 0 ). In a market clearingenvironment, this is a good approximation to real income change, but when output is allocatedby other rationing mechanisms, different estimation techniques are required. 1

The reader may ask why the increase in real income due to the lower cost of consumingthe original amount qo is not included as a direct benefit as well as in the term correcting forthe income effect. The reason is that in the case of a representative consumer, this is a welfareneutral transfer between the consumer and the producer (which may be the government). Weshall see in a non-market-clearing context, the consumer savings might not be transferred to theproducer, and thus should be included in direct benefits.

2\ There are, of course, other effects of projects, including the distributive allocation of such income increases.

Lo\ That is, bP = e.(qI0la) , where e is the income elasticity of demand for good i at initial incomes, prices,and quantities.

.U\ See below.

10

In the case where the price of only one good changes, the last term is an adjustment to theconsumer surplus change, yielding an approximation to Hicks' equivalent variation measure.For a given change in prices, Ap , this adjustment is important if the relevant income responsesof demand, bc , are large. In the case of a price fall Ap < 0 , and for non-inferior goods bis positive, so the correction is negative. Ignoring the income effect over-estimates the benefitsof the project. The situations in which this over-estimation is important are illustrated in thepolicy discussion section (see page 17).

Of course, if the compensated demand curve is used directly to calculate the benefits froma project, it is not necessary to carry out any adjustments of the form described above.However, such an approach requires the transformation of the ordinary (uncompensated) demandcurve into the unobservable compensated version. The value of the approach adopted here isthat it helps us identify those cases in which such a transformation does not improve the benefitsestimate significantly.

(III) Explicit benefit estimation - non-clearing markets.

When project and non-project output is not allocated by a flexible price mechanism,observed prices tell us little about the value of the project to consumers. However, Figure 1 canstill be used to estimate gross benefits due to an increase in output from qo to q1 . In Figure1 for example, area A + B still represents the gross benefit to the representative individual,assuming no income effect. However, it is harder to estimate demand prices at the pre- andpost-project quantities when markets do not work in an orthodox manner, and so alternativemethods are often invoked.

Before discussing these alternatives, we note that if some estimate of marginal willingnessto pay (i.e. shadow prices) at pre- and post-project outputs could be elicited, equation (1) couldbe applied immediately. Accounting for the income effect would require calculation ofAm = -Apqo , using the above price estimates, which represents savings on pre-existingconsumption of the project good. When the good is not allocated by a market clearing price,these savings may be in terms of reduced queuing times,n greater reliability of supply, orbetter quality, all of which represent a reduction in the real cost of consuming the product.However, now these consumer savings should be included as direct benefits also, since theyderive from a reduction in waste, not a reduction in profits to the producer. In this case,equation (2) should be modified to read

B = p IAq- 1Ap.Aq +1(Ap.b)Am + Am (3)2 2

The implications of this observation are outlined in the "Policy discussion" below.

1L\ Waiting times for trucks wishing to cross the Jamuna river in Bangladesh are of the order of forty hours.Whether construction of a bridge would increase the number of crossings, the real income savings on existingcrossings would appear to be high. (Jamuna Bridge Project, Economic Evaluation, Jan. 15, 1992).

11

(a) Some Bank estimates

Using the ideas developed above, two methods of benefits estimation used at the Bank arenow examined. These can be potentially quite misleading, and explicit recognition of theirlimitations and underlying assumptions is necessary if they are used in appraisal documents. Thefirst approach uses the cost of the next best alternative method of production, but for largeprojects this number may be quite unrelated to the realized benefits. The second approach usesrevenue estimates, with certain pricing assumptions, as a proxy for benefits.

() Least alternative cost

In many large projects it is more or less assumed that a certain increase in output wouldbe justified under a number of different production plans. For example, it might be assumedthat power shortages are such that the benefits of additional capacity are sufficiently large tojustify the use of a number of different technologies. Given a particular chosen technology, theadditional output generated is then valued at the cost of producing it by the next cheapest means.

The logic behind this approach is unclear. In general, the cost of the next best means ofproduction and the gross benefit, measured by area A + B in Figure 1, will be unrelated. Forinstance, if there is no technologically possible alternative, then benefits are infinite whencalculated in this way. Similarly, alternatives with only slightly higher costs may underestimatebenefits. This is shown in Figure 2. A project increases output from qo to q1 . In additionto the project under consideration, two alternative projects can yield the same increase in outputat cost C1 and C2 = C1 + U + V respectively. Clearly, if the first alternative is the nextcheapest, it underestimates gross benefits. If it is not available, and the second alternative is thenext cheapest, benefits are considerably overestimated.

In practice, when projects are proposed by country officials, they must be justified by a largeenough internal economic rate of return, based on some quantitative evidence. If it is claimedthat the alternative cost method conservatively estimates project benefits, then some knowledge -possibly quite imprecise - of the underlying demand curve must exist. But such knowledgeshould then be used to calculate more reliable measures of benefits as described above, usingwhatever demand information is available.

Although it has been argued that alternative cost is not a very reliable measure of grossbenefits, it can be very useful in designing optimal combinations of projects. It is then anextension of the concept of opportunity cost to lumpy projects, and requires less knowledge ofdemand curves. The technique is discussed by Starrett (1988), and allows different alternativesto be compared. Since the issue here is that of calculating benefits from a specific project, anexposition of the method is deferred.

12

p

V

U

1 01qO qI

Figure 2

(il) Revenue measures

Even though prices may not initially correspond to marginal willingness to pay, they aresometimes used to estimate benefits. There are two circumstances to consider, correspondingto the absence or presence of price reform accompanying the project. When prices are keptbelow their market clearing level, the projected revenue generated by the investment is usually,but not necessarily, an underestimate of gross benefits. If price reform corresponds to settingmarket clearing prices, benefits are underestimated.

(1) No Price Reform:

If there is excess demand at pre-project prices, and prices are to remain fixed, then usuallythe projected increased revenue from the project will under-estimate benefits. This is certainlythe case if the expansion of output is just sufficient to make the pre-project price, p* , equalto the ex post marginal willingness to pay. This is shown in Figure 3 where output increasesfrom qo to qI .

However, if the expansion is large, say to q! in Figure 3, the increased supply valuedat p* could overestimate gross benefits. This is the case if area Q is greater than area S .Of course, ex post, the full increase in output would not be consumed at the price p* . But therevenue method is used when demand information is scarce, in which case the analyst will notknow that q2 represents over-supply at the price p* . If excess supply at p* could bepredicted before the project was undertaken, then the demand characteristics used to make sucha prediction could be used to calculate benefits more accurately in the first place.

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FIgure 3

(2) Price Reform

When output is expanded by a fixed amount, projected revenue is used to estimate gross-benefit which, when income effects are small, is given by area A + B in Figure 1. However,it makes no difference who actually gets the money, unless public and private income are valueddifferently. The institution of price reforms which clear the market allows the analyst to(under-) estimate benefits as the product of the new price and the increase in output, area Din Figure 4. But even without the price reform, as long as the market clearing price p1 cabe calculated, and there is excess supply at the distorted prices p*' (i.e. as long as output is stillcapacity constrained), undertaking the reform does not actually increase gross benefits. In fact,if p1 - the future market clearing price after the project - can be estimated, then it is likely thatpP - the pre-project market clearing price - can also be estimated, with a similar degree ofaccuracy. In this case, the more accurate measures of equations (1) and (2) can be used tocalculate benefits.

Only when output is not capacity constrained at unreformed prices p* will inefficientlylow prices reduce potential benefits. But this is an argument about net benefits. Thus pricereform is important in our present setting when the increase in output or capacity is large enoughto satisfy all demand at p*'. If the marginal cost of producing is greater than p* , then a priceincrease is desired. No distributional considerations are necessary, since we have assumed arepresentative consumer.

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pO

P* --- ------D ------ -

FIgure 4

(IV) Distributional issues

The formulae of equations (1) and (2) can be adapted to a situation where the distributionof welfare gains is important. Hammond (1983) argues forcibly that far from avoiding inter-personal utility comparisons, calculating the unweighted sum of individual surplus measures

"makes very special inter-personal comparisons to the effect that everybody'smarginal dollar is worth the same..."

While the welfare economic basis for including distributional weights is independent ofthe size of the project, in practice the appraisal of large projects may be expected to requirespecial consideration. This is because large projects have the capacity to affect a largeproportion of the population, and also may result in particularly large income gains or losses tosome individuals.

If a wide range of individuals is affected by a project, the task of redistributing net gainsfrom the "winners" to the "losers", a post, may be problematic. In this case we may beespecially justified in incorporating distributional judgements into the a ante appraisal. Thisargument essentially recognizes that it may be dangerous to assume redistribution will occurwhen the administrative and political costs could be high. Of course, in some cases, such asdam projects, the losers (those who need to be relocated) are relatively easy to identify and theproject analyst might assume that the necessary ex post redistribution takes place.

As we have emphasized previously, large projects have the capacity to change the incomesof some individuals considerably - for instance those of farmers benefiting from an irrigationproject. The decision to go ahead with a project of this kind should probably be influenced bywhether owners of large estates or peasant farmers are the main beneficiaries.

15

There are two main arguments against including distributional weights in projectevaluation. Firstly, data may be unavailable, in which case differential weights are impossibleto assign within any logical framework. This observation is irrefutable, and when it is hard toidentify the winners and losers, uniform treatment is probably the best choice.

The second argument, recognizing the political economy aspect of project selection, is thatany project can be made to look favorable by choosing weights appropriately. This is certainlytrue, but the suggestion that the use of weights is the only means of exerting political influenceon project choice is absurd. On the contrary, the use of weights at least makes politicaljudgements and preferences explicit and open to debate. Certainly the covert use of weights isto be avoided, and appraisal reports should clearly document the choices made. The necessarymodifications to the earlier formulae are presented and discussed in Annex 1.

(V) Policy discussion

This sub-section ties together the preceding discussion to identify conditions under whichthe income effect is likely to be important, and presents some stylized examples to illustrate thearguments.

(a) When to Include the income effect

Equations (2) and (3) suggested modifications to standard calculations of benefitsaccounting for the income effect. For operational purposes, it is necessary to have some ideafor which kinds of projects these adjustments are relatively important. It can be argued that,ceteris paribus, it is more likely to be significant

(a) when the income responsiveness of demand for a good whose price changes ishigh; and(b) when output is allocated efficiently by price rather than by quantity rationing.

The first condition is intuitively clear; the higher the income elasticity of demand for a projectgood, the greater the effect of additional savings on previous purchases on aggregate demand.The second result stems from the fact that since the savings on previous purchases represent adirect benefit to consumers under non-market-clearing price allocation, the adjustment for theincome effect is of relatively less importance. Clearly, it is important that this effective directincrease in income is explicitly included in the measurement of benefits.

(b) Identifying projects where income effects are Important

The discussion above suggests that accounting for inuome effects in large projects is mostimportant when net incomes are not affected greatly, and output is allocated via the market, bothwith and without the project. The change in income due to a project is directly determined bythe response of aggregate production (including trade) as illustrated in the examples given below.

(i) Transport: Suppose a bridge is constructed across a navigable river, and that beforeconstruction fares are high enough to reduce queuing times to moderate levels; in particular, thefares are high enough to allow the ferry companies to operate a large enough fleet. Suppose alsothat goods traded across the river are relatively income elastic in demand. In this case the

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Box 1: Estimating benefits from the .'liko Jydroelectrke PrqJect.Additional supplies of electricity are hard to aeii China because market picesrdnot measure marginal benefits. The two athods used it the appraisal reportarecompared with shadow pricing tecniqes incorporating consumer surplus and incomeeffects. The data are simplified to keep the ideas clear, and we calculate benefits onlyfor a: single year when the project is "up and running".

The project yields an extra 0.5x10 kWh ='Aq units of power, in addition to 7x10kWh = q0 . The value of an extra uit is approximated by the value of additionalproduction attainable, po Y 1.0/kWh this would be the market clearingpriceinitially, or the initial shadow price of output. The extra power supply is estimated toralse income by approximately Y 5'00 = Am, which we assume here to representsavings due to fewer outages. The p oject apprasal reported.benefits calculated asrevenue collected (using a price p*' = Y 0.072/kWh, "based on financialrequirements") and best alternative cost of supply (calculated as c* = Y 0.153/kW)

Financial revenue method: BV = p*q Y 3 .T

Alternative cost method: B., * o*.Aq . 7,6x10s

Neither of these measures include savings from fewer outages.terms. The other measures described in the text require knowledge of the marketclearing price after the prjet Given that electricity is relatively price inelastic, forillustrative purposes, we take p1 = 0.80/kWh . We now.include thieinduced.savings, Am , in benefit es'imates,an calculate three measures: revenue at post-project market clearing prices; gross cosumer surplus; and consumer surplus adjustedfor the income effet..

Shadow revenuemethod Am + pt.Aq Y 9x106 .

Consumer surplis.method B B V2(p -p)4q 50'

Income effect adjusted: Bi. Po+ (plp .boAm Y (9;S-0.5b xf0s

income effect adjustment will be relatively important. However, if the river is not navigablebefore the project, or if the ferries do not charge market clearing prices, then the value of thedirect increase in income from greater trade opportunities and high waiting costs etc. will faroutweigh the correction for the income effect to consumer surplus.

(ii) Power. It is sometimes argued that countries face "power shortages", constrainingeconomic development. While there may be less power generating capacity than desired, sucha general claim could be made about nearly all goods in all but the most affluent of economies.To the extent that these shortages are manifest in the existence of idle productive machinery and

17

consumer rationing, the scarcity is likely to be symptomatic of non-market clearing prices.There may well be reasons for employing such prices, but in any case, we may expect thatmaking adjustments for income effects will not be a high priority.

Note that in the case of large power generation schemes in small countries, the benefitsmay derive largely from export carnings. If such trade relations are bilateral, it is necessary tohave a good model of non-competitive .aarket interactions. In particu'ar, if the exportingcountry does not hold a strong bargaining position, or is somehow reliant upon a large importingneighbor, the income gains may not be very significant. This is an important issue for the ArunIII project in Nepal, if export to India is proposed. Experience from the Itaipu dam on theParaguay/Brazil border could be illustrative. Due to internal economic problems and adjustment,Brazil has, at least temporarily, suspended payments for imported power from Paraguay.

(iii) Social Sector projects: It is hard to imagine a primary health care or educationproject that does not at least aim to have an impact on incomes. However, the incomeresponsiveness of demand for these services, especially education, may be quite high. In thiscase, the correction could make a difference, but it is probably a good approximation to ignoreit, at least in initial appraisals, especially since these services are not often allocated solely byprice.

(VI) Further income-related issues In benefit estimation

Two additional effects of large projects that may be attributed to income changes arebriefly discussed. The first relates to a ante and ex post willingness to pay, and the secondto regional demographic changes.

Consumer sovereignty: Consider a large health care project. If consumer benefits aredirectly solicited, say by asking agents their willingness to pay, they may be underestimated.This is because if incomes are very low and perceived as fixed, willingness to pay for improvedhealth may be quite low. However, if improved health increases incomes sufficiently, ex postwillingness to pay may be much higher. It is this value that we want to measure to value thebenefits of health care projects. Only if agents are aware of the increased income they will earnwill they report high enough values." This, of course, requires credibility on the part of thegovernment as regards the delivery of the proposed service.

Demography: Suppose an irrigation and water supply project increases the income of aregion to such a degree that the supply price of labor rises.14 The large project could theninduce an inflow of migrant workers from a neighboring poor region, as has occurred in north-

13\ This point is different to the problem of revelation of preferences for public goods. It relies more on thetheory of merit goods.

JA\ This phenomenon is observed in developing and developed countries, where individuals with higher incomeswould rather be unemployed that take some low paid jobs.

18

western India where Bihari workers till well-irrigated Punjab soils.Is This is an efficientdivision of labor, contingent on one's attitude to the distribution of income. However, suchincome induced demographic effects should be anticipated so that potential social and politicalproblems can be foreseen.

(VII) Summary

Ideally, the response of production activities throughout the economy, and their impact onfinal consumption, should be taken into account when projects are large. In general this wouldrequire the use of CGEs, but as an approximation gross benefits can be derived from an estimateof the aggregate demand functions for project goods. Certainly, profit at initial shadow pricesmay not be an indication of a socially desirable project, since these measure only marginal socialcosts and benefits. Because shadow prices change, some estimatioin of demand curves isnecessary.

Consumer surplus is the standard measure of benefits from discrete price and quantitychanges. If compensated demand functions are not computed, accurate estimations of benefitsrequire adjustments for the income effect. However, it has been argued that such adjustmentsare only important if the income elasticity of demand is high, and if market clearing prices existbefore and after the project. If output is allocated in some other way, it is important to includethe direct benefit from reduced costs of consuming the original output (e.g. due to reduceddelays etc.). Adjustments for income effects are then of relatively low priority.

Finally, alternative cost and revenue methods are of some use when output is not allocatedby a flexible price mechanism. However, the assumptions behind, and limitations of, theseestimates should be clearly stated in the apprais al document. Table I summarizes the alternativebenefit measures, some of their shortcomings, and the data requirements of each.

Finally, the distributional consequences of large projects may require special attention andexplicit inclusion in the appraisal process. This is because in many (but not all) cases the largenumbers of winners and losers may be hard to identify, and the administrative costs ofredistributing income ex post may be prohibitive.

1\ From personal communication with C. Perry, New Delhi office.

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Project * Aq Gross benefits measure Comments

Small project Shadow revenue = p.Aq p=shadow price;OK for small Aq.

"First stage" appraisal Only sufficient conditions. IfLarge project Reject if pre-project shadow the analysis is inconclusive,

profits < 0 estimate benefits explicitly.Accept if post-project shadow

profits > 0

Best alternative cost = Ba Bears no strict relation tobenefits.

Revenue at financial prices, When output is not rationed byBft = p. Aq price, this can either under- or

over-estimate benefits.

Revenue at post-project market Omits consumer surplus;clearing prices plus change in estimate of pl needed when

income; output quantity rationed; under-Bs = pt.Aq estimates benefits.

Gross Marshallian consumer Good approximation, especiallysurplus; in rationed markets. This gives

B. = B,, - 1Ap.Aq an overestimate if incomeelasticities of demand are large.

Surplus adjusted for income effect; Income elast. of demand, bo,Be = B, + ½(Ap.bo)Am required. Important if prices

clear market.

Table I Measures of gross benefits fom small and large projects.

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3. Uncertainty, risk, and project design

Most of the benefits, and a significant portion of the costs, of large projects occur in thefuture, after decisions to go ahead have been made. If these values are known precisely, theyshould be aggregated using the accounting rate of interest, based on the social rate of timepreference and/or the shadow price of private investment. This is the so-called "risk-free"interest rate.

But future values are uncertain. One characteristic feature of large projects is their longtime horizon; planning, construction, and operation may take many years, in which case thereis bound to be significant uncertainty regarding the prices and quantities facing the project indifferent phases. Fuel and commodity prices, demand growth, inflation, interest and exchangerates, and technological and regulatory developments are just some of the sources ofuncertainty.16

Two issues then arise: how should uncertain future values associated with a particular planbe aggregated?, and what are the implications of uncertainty for project design? The first issuehas often been posed in terms of the desirability or otherwise of the government adjusting itsappraisal for risk: should it bother, and if so, is there a simple method for doing so? Thesecond issue is not about risk, but is essentially about designing projects which make the bestuse of information revealed in the future. This is important in the choice of large projects, sincethey typically involve the long-term commitment of resources in significant quantities. Thiscommitment necessarily precludes future responses to unexpected events (oil price shocks forexample), so flexibility is valuable.

(1) Accounting for risk in project appraisal

A traditional rule of thumb, deriving from the Arrow-Lind theorem (1970) and espousedby Little and Mirrlees (1974), has been that public project appraisal should not incorporate riskpremia. Others have taken issue with this approach, arguing that some risks are notdiversifiable, even in the public sector. In fact it is often noted by protagonists of the rule ofthumb that some circumstances may invalidate it. These include

(i) the project representing a large proportion of the government's budget;(ii) the returns to the project being correlated with the performance of the wholeeconomy; and(iii) the distribution of risk amongst individuals being uneven.

The first of these circumstances is clearly relevant to the present context. The second will oftenbe important, especially if the project provides inputs into other sectors. The third circumstanceis a special case of the first, since for the group of affected individuals, the project is, in effect,large. It is important when the project's impact cannot be spread over a large number ofindividuals.

Jf\see Crousillat (1989).

21

Next we briefly note the importance of using statistically sound techniques even when riskis not explicitly accounted for in project evaluation. This involves the use of mean as opposedto modal values of central tendency. Then we look at specific risk adjustment methods: thecertainty equivalent approach, whereby expected values are modified and then aggregated withthe risk free discount rate; and the risk-adjusted interest rate method, whereby expected valuesare aggregated directly with a modified discount rate. Some brief comments on the distributionof risks and the capital asset pricing model end this sub-section.

(a) Expected and modal values

Before addressing the three issues above, it is perhaps necessary to point out that even ifthe government is risk neutral, it should base appraisals on the expected value of future benefitsand costs, and not their most likely, or modal, values. Techniques which use most likelyscenarios put no weight on other possible outcomes, and are vulnerable to over-optimisticappraisal if the probability distribution of net returns is skewed to the left.17

Consider a project with returns tomorrow of $1 with probability 0.6, and -$1000 withprobability 0.4. Decisions based on the most likely outcome ($1) would not be supported bymany rational economic agents. Of course, this example ignores the possibility of unusuallyhigh benefits or low costs. When the distribution of net returns is skewed to the right, modalappraisal will bias against the project. However, it is suggested that in the case of largeprojects, with long complicated construction stages, the downside risk is greater than theupside.18

The avoidance of modal values (or EGAP - Everything Goes According to Plan -values) is particularly important in large projects facing so called "institutional risk". Thisterm typically boils down to mean the risk of delays, either in procurement, construction,financing, or maintenance, etc. It is hard to put probabilities on these risks, but based onprevious experience in the country and in the same sector in other countries, some idea of thepossibilities can be obtained. Over-optimism should be avoided.

(b) Risk adjustments

Risk is important if the marginal social utility of income is decreasing. In this case aproject with a certain return of $z is socially preferred to an uncertain project with an expectedreturn of the same value. There are two methods of calculating the social value of a riskyproject. One is to adjust the expected values of costs and benefits to their "certaintyequivalents" and aggregate these values using the risk free discount rate. The other is to use the

1l This point has been made by Anderson (1990).

J\ For evidence on cost oveuns etc., see Besant-Jones, in IBRD (1989).

12\ Salop (1991). In fact, it could be argued that plans are so infrequently met that the most likely outcome andthe EGAP outcome do not coincide.

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unadjusted expected values, but to aggregate them over time using a modified, or risk adjusted,interest rate.

(1) Certainty equivalents

Using the first method, Anand and Nalebuff (1985) have illustrated how the proportionaladjustment to expected values of future variables depend on the variance of the project's returns,their correlation with per capita national income, and the degree of social risk aversion. Theyshow that if Y is national income per person and Z is project output per person, then thecertainty equivalent value of project output, z , is approximately"

z = - [Var(Z) +2Cov(Y,Z)] (4)2 (Y+Z)

where bars denote expected values, Var and Cov are the variance and covariance operatorsrespectively, and R(x) is the coefficient of relative risk aversion at income x , usually takento lie between 1.5 and 2.5 .

The qualitative results are as we would expect. Higher variance means more uncertainty,and thus a larger proportionate risk deduction. Similarly, if the project's outcome is positivelycorrelated with non-project national income, the project's variable performance adds to thevolatility of total national income, implying a negative adjustment. If the correlation is negative,the project dampens the volatility of total national income, and a positive adjustment to theexpected value should be made.

Quantitatively, the adjustments brought about by the correlation effect seem to be moreimportant than those due to the project's own variance. In analyzing the adjustments to expectedvalues for a project negatively correlated with non-project national income, Anand and Nalebufffound that the (positive) correlation term could be as much as eight times as large as the(negative) variance term.21 The net adjustment to the expected value of project benefits wasof the order of 44%. It would be very hard to justify the omission of this adjustment.

Anderson (1989) has recently argued that most appraisals should not include riskadjustments, except under the usual circumstances of very large projects and/or high correlationwith national income. He presents a "rough and ready" approach,2 based on subjectiveestimates of means and correlations, for determining whether adjustments are likely to benecessary. This approach, and the hypothetical case study he presents as an illustration, are akinto the examples of Anand and Nalebuff, with the addition of a little extra probabilistic structure.

ZQ\ See equation (7), Anand and Nalebuff (1985).

al In the example, the project's outcome range was 5% of national income.

a\ Anderson (1989), page 26.

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Anderson notes that without recourse to sophisticated stochastic simulation methods, therough approximations typically ignore uncertainties regarding early project development, projectlife, and serial dependencies (i.e. inter-temporal correlations), and only crudely model theinterdependence of project returns with the performance of the rest of the economy. However,these modifications can be pursued once the rough estimates of certainty equivalent adjustmentshave proven to be significant - say of the order of 5-10% or more of expected returns.

(1l) Risk adjusted Interest rates

One way private investment risks are accounted for in practice is through the use of a riskadjusted interest rate. The application of this practice to public project appraisal is the secondmethod we explore. It is noted however, that in the case of large projects, no simple rule canbe given for the size or even direction of the adjustments of interest rates to account for risk.

The simple idea is that if future benefits from a project are uncertain, then the projectshould be evaluated by discounting expected benefits at a higher rate than if they were certain.That is, risky returns are worth less than safe ones, so to reduce the value of risky returnsappropriately, they are discounted at a higher rate. However, the problem with this argumentis that the adjustment to the discount rate varies between periods.

Recall that large projects typically have a long gestation period, so that initially losses aremade, and only later are returns positive. The presence of risk means that the expected size ofthe losses undwestimates their (negative) contribution to net benefits, so they should be evaluatedusing a discount rate lower than the risk-free rate. Thus for periods in which losses areexpected, the risk adjustment to the interest rate is negative. On the other hand, the expectedsize of uncertain positive gains (profits) later in the life of the project ymestimates their socialvalue, so they should be discounted at a higher rate than otherwise. In these periods, the riskadjustment is positive, and in general a single unique adjustment to the interest rate, suitable forall periods, does not exist.

As noted by Anand and Nalebuff (1985), it is possible to find an interest rate, r' , suchthat the sum of expected values discounted at r' is equal to the sum of certainty equivalentvalues discounted at the risk free interest rate, r . However, as the above discussion shows,r' will vary between projects and across countries, depending on the structure of the stream ofreturns. In particular, there is no guarantee that r' > r in general.

The implication for the appraisal of large projects is that the use of "standard" interest raterisk adjustments could be quite misleading. Comparing the internal rate of expected return (i.e.the interest rate at which the discounted sum of expected returns is zero) with some uniform cut-off risk adjusted cost of capital (say r" = (r + x)% with x > 0 ) may give no goodindication of the true social value of the risky project. The appropriate comparison is betweenthe internal rate of expected return and r' , which varies between projects, and bears nopredictable relationship with r + x , for any x . Certainly, if r' < r , then using r + x asa cut-off rate biases against the project. It is thus recommended that risk adjusted interest ratesbe used with special care in large project appraisal. The preferred approach is that of calculatingcertainty equivalents directly, as described in the previous sub-section.

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These arguments have concentrated on project risk only (i.e the effects of the variance ofproject returns), and have not dealt with the issue of correlation with the rest of the economy.The inclusion of the correlation effect will not change the general conclusion of the analysis, andmay serve to magnify the effects.

(ill) Distribution of risks

If the government's capacity to redistribute income is low, risky local projects mayrequire risk adjustments even if they are very small relative to the national economy. Unlessthe government can provide insurance to local residents - that is, promise (positive or negative)external transfers in the case of unexpected outcomes - the variability of local income will lowerthe ex ante value of the project. This is a direct transposition of the arguments above, but servesto illustrate the fact that a water well in a small village, for example, may be considered a largeproject. The methods of adjustment described above can then be directly applied at the villagelevel, with the same caveats holdings for the interest rate adjustment method as above.

(iv) Comment on the Capital Asset Pricing Model

When a private investment is not large and capital markets are reasonably complete, riskadjusted interest rates can be calculated using the Capital Asset Pricing Model (CAPM). Thistheory can be applied to public project appraisal if the price of risk (determined by thecorrelation of project returns and the required return on economy-wide investments) isobservable. However, this is unlikely in many developing countries with thin capital markets,and it may be easier to guess risk aversion parameters and calculate adjusted net present valuesdirectly.

This is the approach advocated by Anand and Nalebuff (1985), but recent work by Dixitand Williamson (1989) suggests that CAPM techniques may be used in a modified form toaddress the problem. Again, their work deals only with small projects, so is not reviewed indetail here.

(I) Project design under uncertainty and the value of flexibility

The discussion above concentrated on the calculation (and risk-adjusted aggregation) ofnet benefits from a particular project. If these net benefits are positive, the government shouldundertake the project rather than do nothing. But the choice is usually not this simple, andquiescence is not the only alternative. Other options include postponing the project, using adifferent technology, or implementing a series of smaller projects serving the same underlyingpurpose.

When the future is certain, a range of relevant alternative plans can be appraised, and theone with the highest present value chosen. This is descriptive of "least-cost" planning, asapplied to power sector investments for instance, if demand and costs are assumed to be knownwith certainty. But when future values are not known, the "least cost" project could turn outto be a very bad choice as future scenarios unfold. For instance, if the import price of oilincreases significantly, it will be to a country's advantage if it can adapt existing power

25

generation facilities to the use of coal. Building a dual purpose power system may involvehigher construction costs, but assures the country of an affordable power supply in adversecircumstances.

This is an example of the value of flexibility in the design of large projects. If theproposed investment is reversible, so that when adverse circumstances arise the investment canbe costlessly diverted to another use, there is no value to additional flexibility. However, fewinvestments, especially large ones, are characterized in this way. It is thus important to havesome means of valuing the flexibility of projects, and this has nothing to do with thegovernment's risk preference. A risk neutral government would prefer a more flexible projectto a less flexible one, since the expected value of future returns is larger. Of course, greaterflexibility is bought at the price of higher initial costs, so there is a trade-off between the two.The importance of these issues in the case of US utilities has been acknowledged, where it hasbeen found that

".. .cost minimization as such was explicitly rejected in recognition of the fact thatflexible plans, able to adapt to a changing world, may be more expensive than aplan designed for one particular but not realized scenario.'

Two techniques for incorporating these ideas into project evaluation are discussed. Thefirst is a robust planning method, also known as multi-objective programming, which essentiallynarrows down the choice of project designs without requiring sophisticated calculations. Thefinal investment choice is made after those projects which perform well under a wide range ofpossible scenarios are identified. The method does not usually isolate a unique optimal projectdesign.

A more rigorous approach is that of option pricing, which explicitly values the optionsafforded a government by remaining flexible. This has the advantage that decisions based onstrict quantitative arguments can be made, and the planner is disciplined to make explicit thetrade-offs behind those decisions. It is more computationally demanding, but approximationtechniques are available.

(a) Robust planning and multi-objective programming

As mentioned above, this technique of choice under uncertainty identifies projects whichperform well under a range of future scenarios. The performance criterion is not necessarilya single valued function of the outcomes (like a social welfare function), and multiple objectivescan be considered. This feature may be especially useful when appraising social sector projectswhere it is hard to trade off, say increased literacy and infant mortality rates. The final choiceof project will require a subjective judgement on this issue, but the analyst may help by reducingthe size of the set of "reasonable' projects.

The technique is illustrated by use of a power sector example. Two attributes are usedto measure the performance of the investment, namely reliability (measured by loss of load

2\ IBRD (1988).

26

probability - LOLP) and operating costs. Different scenarios are determined by demandconditions, energy prices (oil, coal, natural gas, etc.), technical and regulatory developments,and others.

1250 +

j.1000 +

750 +

isa.750 LSaa 2050 .2200 2)350

Figure 5 Illustration of the robust planing method. sOURCE: IBRD (1989).

For a given scenario, the performance of a range of project designs is estimated, and theresults graphed as in Figure 5. The dominant projects make up the decision set, (solid line) andall other projects should be ignored.2 The set of reasonable projects is further reduced byarguing that the extreme points of the decision set are too costly or too unreliable, dueessentially to the existence of significant decreasing returns. However, it is noted that thisactually constitutes a value judgement, and should be justified explicitly.

We are thus left with a "knee set", consisting of the "best" projects, for the givenscenario. A range of possible scenarios is then considered, and the knee sets identified for each.Those plans that fall repeatedly into the knee sets are considered robust, and the choice ofproject should be made from the set of all robust plans. Hopefully, this set is small - so thechoice is relatively easy, but non-empty - so a choice can in fact be made.

M\ The decision set is defined as the set of projects whose performance points fal on the south-west boundaryof the convex hull of the set of all project performance points.

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The process can be made a little more rigorous by attaching probability estimates to thedifferent scenarios. Recalling the distinction made between mean and modal decision techniques(see the beginning of this section), this may well be important, even if only very rough guessesare available. Then the final set of robust plans might be those which are robust with probabilityp ; that is, with probability p a scenario will arise with a knee set which includes the project.

While an improvement over the purely qualitative analysis, this probabilistic modificationmust still be used with care. Suppose a project is robust with probability p = 0.9 . Then weknow that ten percent of the time the project does not perform as well as others, but we do notknow if it performs only marginally worse or catastrophically so. So if the performance issufficiently bad, the expected value of the project could be very low or negative, and analternative one should be chosen. This may be a good way of choosing between projects whichare robust with the same probability.

This technique, like most others, does not deal well with unanticipated events, like aquadrupling of oil prices. However, if reasonably large fluctuations in oil prices are consideredin the range of scenarios, it is possible that some degree of generation flexibility - say in termsof the ability to switch fuels - would have been built into the project design.

(b) Option values

Options theory, as derived from the financial economics literature, can be used toinvestigate quantitatively the value of (i) postponing investment decisions, (ii) installing multi-purpose technology, and (iii) investing in a series of small projects in place of one large one.Operational implementation of the technique for timing decisions is reasonably well developed,but quantitative application to technology and scale decisions is less advanced.

() The timing of investment

Social costs should be thought of as foregone (social) benefits, that is, as opportunitycosts. This is the rationale for valuing inputs and outputs of projects using shadow prices. Forexample, when labor is drawn from another use, it is valued at its marginal product there - thusit is explicitly recognized that the worker cannot be employed in the project and in his/herprevious occupation simultaneously. That is, these two actions are mutually exclusive.

Some cases of mutual exclusivity are less obvious. If an investment is undertaken now,it cannot be undertaken later. To be consistent, we must calculate the net present value todayof investing in the project tomorrow, and count that as a cost (a foregone benefit) whencalculating the net social benefit of making the investment today. This is especially importantwhen future benefits (e.g. demand) and costs are uncertain: if costs turn out to be much higherthan expected, a project begun at time zero may make a net loss which exceeds the foregonepotential benefits that would have been incurred by waiting.

There are two methods for calculating the option value associated with a project. The firstis to follow the argument of the previous paragraph, while the second treats the option to investas an asset in a portfolio.

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(A) Dynamic Programming Approach: Let NPVo be the net present value of theinvestment now if it is undertaken now (time zero). Similarly, NPVI is the net present valueof the investment now if it is undertaken next year (time one). These values include directinputs and outputs only, and it is assumed that all risk is diversifiable, so that the risk freeinterest rate is used to discount future streams. Then the investment should be postponed ifNPVI > NPVo . Alternatively, the project should not be undertaken now if

NPV-NPVI < 0 . (5)

This clarifies why the option value (NPVI) should be explicitly counted as a cost in projectevaluation. Note that NPVo may well be positive, but less than NPVI . In this case it isbetter to invest now than not at all (which may be the only choice available), but it is betteragain to wait till next year to decide.

(B) Contingent Claims Approach: As discussed by Pindyck (1989), an asset portfoliois created, including the investment opportunityz and other assets, such that the portfolio is riskfree. Under these conditions, no assumptions about risk preferences or discount rates arenecessary. It is then required that the other assets have a collective value perfectly correlatedwith that of the project. Setting the return on this risk free portfolio equal to the risk freeinterest rate allows us to calculate the value of the investment opportunity, and hence the optionvalue. This value is then included as a cost in the appraisal of the project to invest now.

We will return to these approaches later when we examine issues relating to imperfectcapital markets. More operational techniques for incorporating option values into projectappraisal have been developed for specific assumptions about the stochastic path of uncertainvariables. For example, Dixit (1992) has noted that time series for exchange rates, naturalresource prices, common stock prices, and other relevant variables can be modelled as randomwalks. He has used this observation to describe a simple adjustment to the required rate ofreturn to account for irreversibility and the value of the option of waiting. If the governmentis risk neutral, or if correlation of project performance with the rest of the economy is low, theadjustment is given by

r .- ---r (6)1-p

where

2\ Note that the portfolio includes the investment opportunity, not the investment itself. This is because we aretrying to evaluate the cost of investing today rather than tomorrow - i.e. giving up the investment opportunity inreturn for the actual investment.

2k\ See Dixit (1992), equation (3), page 113. a2 is the proportional variance per unit time of the stochasticstream of not benefits.

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p= 1+ > 1 .7

If the stream of net benefits is expected to grow at a rate y , then the adjusted required rate ofreturn is given by

rli , .L. (r -p) (8)

which is reminiscent of the formula of the Capital Asset Pricing Model. However, as notedabove, the adjustment to the required rate of return has nothing to do with risk, so is not a "riskadjustment" as in the CAPM. In the context of a risk neutral government, there is no ambiguityover the sign of the adjustment as there was in the discussion on risk analysis. If the investmentis irreversible, It should be required to make an expected rate of return higher than the risk freerate. This difference accounts for the value of the option which is lost when the investment isundertaken.

The quantitative significance of the interest rate adjustment is illustrated by Dixitnumerically. Clearly, if uncertainty about the future path of net benefits is small (i.e. o - 0 ),there is not much to gain from waiting. Similarly, if the accounting rate of interest is high(r -- oo), so that future benefits are heavily discounted, the adjustment is small. Conversely,when uncertainty is large or discounting low, the proportional adjustment increases. Forreasonable parameter values, a = 0.2 , r = 5% , the adjusted required expected rate of returnis r' = 9.3% .

If costs and benefits evolve independently, and grow in expected value at different rates,the formulae above can be modified. Recent work by Crousillat and Martzoukos (1991) hasillustrated this procedure in the case of power sector development. Their work also includes anumber of case studiesP which elaborate on data requirements, estimation techniques, andsensitivity analysis. They found that the option value - a cost not normally taken into accountin orthodox cost-benefit analyses - ranged from one fifth to one third of total costs in differentprojects.

Z These include comparisons of hydro and thernal power systems in Costa Rica, combined cycle, coal, andnuclear power in Hungary, and hydro and other expansion plans for Mali and Senegal.

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(ll) Choice of technology

When a certain method of power generation is chosen, the option to produce by someother means is foregone.' Say the two alternatives are an oil and coal burning furnaces, andassume the country in question imports both fuels. Then we can think of the net returns to thecoal furnace, say, as the savings on foreign exchange from not having to import oil. Inparticular, the alternative to building the coal burning furnace is nol to do nothing, but to buildthe oil furnace. The returns to the project then depend on the relative prices of oil and coal.

In the optimal timing decision of the previous sub-section, it is worthwhile waiting tochoose between investing and not investing in a given project. Similarly, in the present case,there is a value associated with waiting to choose between oil and coal power. The gain fromwaiting, due to better information, must be balanced against the cost of delayed benefits. Thismeans that the required expected rate of return on the project be higher than the accounting rateof interest, as discussed previously.

However, there may be another choice - to build a multi-fuel furnace (MF). In this case,flexibility over future input choice is retained, while avoiding the costs of delayed benefits.Presumably the more flexible technology will cost more to build than either of the two singlefuel alternatives, but the extra construction cost provides extra benefits.

Suppose for simplicity that while the relative prices of oil and coal are uncertain, theiraverage price is fully determined. Then assuming the inputs of the MFF can be modifiedcostlessly, waiting has no value. The required rate of return on the MF is now just theaccounting rate of interest. Thus, if the MFF passes this investment test and the choice of singlefuel furnace project does not pass the option inclusive test, the more flexible technology shouldbe chosen.

The choice between flexible and inflexible furnaces could have been made by comparingthe extra costs of construction of the former with the delayed benefits associated with latter. Themethod suggested avoids making such a calculation, and allows decisions to be made in termsof expected rates of return. Of course, if both alternatives fail, or both pass, their respectivecriteria, explicit comparison of delayed benefits and extra construction costs is necessary.

Of course, if the uncertainty over future prices is not large, then waiting is preferred toinvesting in the flexible technology. Similarly, if the construction costs of the flexibletechnology are much greater than the other alternatives, it will probably be best to wait. On theother hand, if future relative prices are highly uncertain, or if the extra cost of building the MFFis not substantial, the flexible technology should be preferred.

2JX Of course, an altemative generation plant could be built, but in the medium term we assume the countrydoes not have access to the required capital.

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(111) Small versus large projects

The previous two sub-sections have dealt with the need for flexibility when projectinvestments are irreversible and future returns are uncertain. Flexibility can be attained bypostponing decisions or by using more adaptable technology. A hybrid of these two approachesis to choose a series of small projects instead of the large one. In this way, not all benefits aredelayed, while the chance of ending up with an over-extravagant construction is reduced.

Of course, there are disadvantages to the use of small projects, deriving from economiesof scale, duplication, disruption of existing projects,29 etc. On the other hand, if thegovernment faces borrowing constraints, it is more likely to be able to finance a series of smallprojects than a single large outlay. This may particularly be the case with respect to privateinvestors, whose willingness to invest may decrease quickly with the magnitude of their riskexposure in developing countries. Indeed, it may be the case that small projects are necessaryinputs into the construction of bigger ones (e.g. access roads in transportation projects, pilotprograms in health care projects) in which case the difference between the direct cost of a largeproject and that of a sequence of small projects may not be extreme. These points aside. it isargued that, ceterls pafibus, irreversibility makes a sequence of small investments moreattractive than a large project.

Once again, the conclusions do not derive from social risk aversion. In a similar vein tothe flexible technology case above, a higher social discount rate should be used in the valuationof a large project than for a sequence of small projects. Of course, the sequence of smallprojects is still open to uncertainty, so the appropriate discount rate still incorporates an optionvalue adjustment. However, this is smaller than for the large project.

These arguments are particularly suitable to capacity choice problems, as opposed totechnology choice. In the power station example above, for instance, building a sequence ofsmall oil burning furnaces will not protect the country against future oil price rises. But for agiven path of future oil prices, if demand turns out to be less than expected, the country is notsaddled with vast amounts of excess capacity and debt. The El Cajon hydro-electric plant andPuerto Castilla, both in Honduras, are cases in point. Both are reported to have been far toolarge for the realized demand.

(III) Summary

Uncertainty affects project appraisal for two reasons. First, if the government, acting inthe public interest, is risk averse, then variable outcomes are costly compared to certain ones.This does not matter when projects are small and uncorrelated with national income, since thegovernment can diversify the risk away. But very large projects are neither small (!) noruncorrelated with the performance of the economy, so their riskiness should enter projectappraisal explicitly. This can be effected by (i) calculating "certainty equivalent" measures ofcosts and benefits and discounting them at the risk free interest rate, or (ii) discounting the

\ e.g. adding a lane to a bridge or highway.

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expected value of net benefits at an adjusted interest rate. It should be stressed that in the caseof large projects, the second method must be used with care, since it is not true that the adjustedrate, r' , will always be greater than the risk-free rate, r . In particular, when project costsare sufficiently uncertain, it is possible that r' < r ; that is, the adjustment is negative.

Second, even if the government acts in a risk neutral fashion, it would prefer not tocommit itself to large investments which may turn out to have low returns. But large projectsare mostly irreversible, and so have exactly this commitment characteristic. There is then avalue to postponing the investment, to investing in flexible technology, or making a series ofsmall mvestments over time. Each of these must be traded off against the associated costs - e.g.delayed benefits, additional capital requirements, loss of economies of scale. The issues andimplications of uncertainty are summarized in Table H.

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Uncertainty Issue Small Projects Implications for Large Projects

1. Risk can Invariably be Ignored. 1. Risk adjustments should be included.

2. Use expected values of benefits 2. A further reason to include risk adjustments is thatand costs, not modal or "EGAP" outcomes of large projects are likely to be correlated

RISK (Everything Goes According to with national income.Plan) values.

3. Risk adjustments for appraisal:3. If project has concentrated (a) Certainty equivalent method:impact, risk may not be spread. (I) adjust expected net benefits for risk, usingThe project should then be treated coefficient of relative risk aversion;as large, in terms of Its risk (1l) aggregate these using riskfree interestanalysis. rate (=social rate of discount).

(b) Risk adjusted Interest rate method:(I) adjust interest rate from r to r' for risk;(ii) calculate discounted sum of expected net

benefits using r.

4. Risk adjusted interest rate may be higher or lowerthan risk free rate when project is large. Cnnotroutinely use CAPM for large projects.

1. If inputs to small project can be 1. Most large projects involve large, long-termeasily re-deployed in other uses, resource commitments.there is no need to account forirreversibility. 2. Future uncertainty means waiting and retaining

flexibility over decisions is valuable.IRREVERSIBILITY 2. Otherwise, the Issues are

similar to those in the large 3. Robust planning method: identify project designsproject case. which perform well in a variety of different scenarios.

This method narrows the choice of project designs, butdoesn't give unique decision rules.

4. Options method: there are three choices.(a) liming: Postponing the project may offer the

chance of obtaining better information later.The option of investing is kept open. Is thecost of such deferment high?

(b) Flexibility: Using technology which can use arange of inputs, or produce a range of outputs,allows the investment to yield higher benefitsas relative input and relative output priceschange. The options of what to produce and howto produce it are kept open. Is the initialcost of doing so high?

(c) Sequencing: A sequence of small projects couldalso allow a degree of flexibility, althoughobviously sometimes this is impractical. Are

o_RINgfor S p-ReWappraW.foregone scale economies significant?Table II Accounting for ancertainty in project appraisal.

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4. Macroeconomic issues

(1) Introduction

When large projects are undertaken in small countries, there may be significant impactson macroeconomic variables. Internal and external financing requirements may affect the budgetand current account deficits, while rigidities and imperfections in local markets can impedeadjustments to new productive capacities. There are three broad categories of issues: what arethe macroeconomic effects?; do they require policy responses outside the usual gamut of projectappraisal?; and are they less significant or problematic in the case of small projects?

It should be noted that with respect to macroeconomic issues, the main definingcharacteristic of largeness is relative to the government's budget position. To this end, in manycases discussed below, one should perhaps speak of large programs, rather than large projects.A clear example of this is a macroeconomic adjustment program, which is typically not thoughtof as a project to which cost-benefit analysis is appropriate. However, recent work by Kanbur(1990) has shown how standard analysis can be applied to such stabilization programs, whichare clearly good candidates for large project analysis as defined here.

We consider a "typical" project undertaken by the government and financed by foreign anddomestic capital. First we assume that the supply of foreign capital is fixed, and investigateissues of macroeconomic feasibility/affordability. Concentrating on thefeasibility of the projectallows us to determine what kind of complementary policies the government will need to adoptto complete the project successfully. Macro and micro policy responses are considered, and theissue of debt sustainability discussed. Then, if financial feasibility is confirmed, the issue ofmacroeconomic desirability may be addressed, with the use of shadow prices.

Finally, some sectoral issues are addressed. Does a large project act like an externalshock to the economy, necessitating significant reallocation of real resources in imperfectmarkets? If these reallocation problems are thought to be severe, appropriate macroeconomicpolicies should be followed, although it will be argued that orthodox Dutch Disease conclusionsmay not pertain to many Bank sponsored projects.

It should be noted that in general, to arrive at specific recommendations regarding eachof the issues of this section, macro-models of various degrees of sophistication need to beconstructed. Such explicit modelling will not be pursued here, since any general framework willbe necessarily complex, and will quite likely miss important country specific details. Countryeconomists and operations staff are expected to possess a comparative advantage in performingthe necessary modelling exercises. Rather, this section should be used as a inventory of possiblemacroeconomic effects and problems that may be associated with a large project, withsuggestions as to their implications for appraisal.

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(I) Macroeconomic feasibility

The availability of resources for financing a large project is initially examined in termsof savings and foreign exchange gaps in a fixed price framework. This is followed by aninvestigation of complementary macro and microeconomic policies which may be able tomobilize sufficient resources to fill these gaps. This is followed by a discussion of theimplications of relative price and real exchange rate movements for debt sustainability, or long-run affordability.

(a) Affordability constraints and financing gaps

It is useful to note initially that it is difficult to find a project which is strictly unaffordablefor a particular country. For instance, the government could ban all imports except thosenecessary for the project, thus freeing up foreign exchange to pay for imported project inputs.While such a draconian measure is unlikely to be desirable, the fundamental constraints are locallabor, land, natural resources, and technology.

The above serves to illustrate the fact that the question we wish to address is that of theaffordability of the project with respect to some institutional status quo. In particular, givenmacroeconomic and other government policies, e.g. military and social sector objectives,industry, trade, and wages policies, etc., and constraints on policy instruments, e.g. taxes, canthe financial requirements of the project be absorbed by the economy? If not, what kind ofpolicy changes are effective in reversing this position? This leads naturally to the desirabilityissue, since some draconian means of closing the financing gaps, such as those mentioned above,are clearly unacceptable.3

While the supply of foreign capital is invariably tied to a certain project (or program) innominal or official terms, fungibility suggests that supply may be treated approximately asexogenous. Certainly this is the case with small projects, but may be close to true even for largeinvestments. If we assume a fixed exchange rate and constant relative prices, affordabilitythen becomes an accounting question, and can be investigated within the simple two-gap macroparadigm. We will see that the introduction of flexible prices and exchange rates, can haveimportant implications for the size of the burden of external debt in real terms.

Consider a large project that requires domestic and foreign inputs. To pay for theinvestment, the government must have access to a sufficient total quantity of resources, whichmust be of the right mix (domestic/foreign). The total supply of funds is total national savings,equal to unconsumed national income plus foreign capital inflows. The domestic/foreign mix

Q\ Forced labor is a kind of lump-sum taxation. Such instnnetts may be ruled out by the goverment apriori.

U1\ This may not be quite so innocuous an assumption in times of global disequilibrium and internationalreorganization. With new countries of the former Soviet Union and east Europe etering world financialmarkets, other countries may find the supply of foreign exchange becoming more elastic.

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is determined by the country's trade performance and access to foreign capital markets. Theproject is infeasible if the savings and/or foreign exchange constraints bind.

In the simplest type of fixed price two-gap model, savings and non-project imports aredetermined in a Keynesian fashion as proportional to income. If net foreign capital inflows andexport earnings are exogenous, it is unlikely that both internal balance (i.e. total savings = totalinvestment) and external balance (i.e. foreign currency receipts = imports) will be satisfied.If, with the proposed project, these accounting identities are not satisfied, quantities must adjustto fill the gaps. With more elaborate and/or disaggregated models of savings and investmentbehavior, relative price movements act to bring such adjustment about.

The project itself may induce higher domestic savings and foreign exchange reserves. Ifit increases future income, savings initially may fall, as agents adjust their life-cycle decisions.However, the higher future income would presumably lead to higher future savings which, ifthe project is debt financed, could be used to pay off the debt. The distribution of income gainsmay well be important in this respect. If the gains accrue to low income individuals andfamilies, the additional savings may not be great. This point identifies a trade-off betweenpoverty alleviation and affordability. Clearly, the more effective the government's socialtransfer system, the less severe the trade-off.2

(b) Complementary macroeconomic policies

If the project is not expected to automatically produce or stimulate extra savings and lowercurrent account deficits immediately, the government may help to effect such changes throughthe use of complementary macroeconomic policies. The efficacy of tax measures in increasingnational savings has been questioned by Barro (1974) and many others. The extreme Ricardianequivalence result does not hold because taxes are not lump-sum. Also, higher taxes may bemore effective in narrowing the savings gap in developing countries since without wellfunctioning capital markets, many agents will be credit constrained.

On the other hand, the government may face an internal transfer problem, in that anyinduced private savings must be available to pay for the project. They must either be held asgovernment bonds, or if invested in private firms, the coverage of corporate taxation must besuitably extensive. The first option requires public confidence in the government's ability toservice its bond issues, and the second may be problematic in low tax capacity countries. Theworst outcome for the government would be for all induced savings to flee the country.Responding to this with capital movement restrictions may discourage other private foreigninvestment, while high real interest rates may depress private domestic investment.

Export enhancing programs may be advocated to narrow the external gap, whether itderives from the need to encourage private savings or otherwise. For some countries, theconstraint on export earnings may arise indirectly from savings constraints. If for manufactured

J\ In some cases, it is hard to divert the gains from a project towards the poor, especially in industrial projectsproducing tradable outputs.

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goods, export earnings are determined by domestic productive capacity, diverting productiveresources from the non-tradables sector into the export sector may narrow the foreign exchangegap. This will ultimately require a reduction in consumption - i.e. an increase in savings. Ofcourse, in the short run, undesirable transitional costs may be incurred.

On the other hand, if the country cannot sell as much as it wishes at world prices theforeign exchange constraint is independent of the savings constraint. This is true for somecommodity and agricultural exporters, especially if supply is generated by a small group ofcountries. Depending on the behavior of other exporters (and the advice they receive from theBank and Fund) the effective demand for a single country's exports may be quite inelastic.

It could be argued that the foreign exchange gap may be of less importance than thesavings gap for many small countries because of the complementarity of domestic and foreigninputs into the project. Accordingly, a country's "absorptive capacity" constrains its ability totake advantage of foreign aid flows, this presumably meaning that the country is unable to usethe external resources efficiently. Domestic resources such as land and skilled labor may notbe easily imported, while domestic organizational and institutional capacity are often weak.33

However, it is hard to see how increased domestic savings would improve the absorptivecapacity of the country.

(c) Microeconomic reform

The government may seek to narrow the internal gap by targeting selected publicexpenditure policies in other sectors rather than attempting to stimulate savings with broad fiscaland monetary measures. In this case, each sector of the economy which accounts for asubstantial part of the government's discretionary spending should be analyzed.

The expenditure reforms can have two effects. Firstly, they may be welfare improvingby themselves - for instance inefficiently high fertilizer subsidies, or inefficiently low usercharges are good targets for government savings. Similarly, the privatization of some publicenterprises may provide efficiency gains (but only if the resulting private firms are able toreduce costs and improve profitability). However, it is important to consider the distributionalimpacts of the removal of subsidies and the imposition of charges: the net impact will dependcrucially on the capacity of the government's social transfer system to carry out the necessaryredistribution of gains.

Secondly, even if the reduction in spending causes a welfare loss, it must be judged inrelation to the possible gain from the project. Without resorting to explicit calculations, it maybe possible to identify *priority expenditures" which are deemed to be of more social value thanthe project. Such subjective decisions may be based as much on historical precedent as socialpreference orderings, but are helpful in identifying possible sources of government savings.

1\ It is noted however, that some countries now employ wetern consulting agencies to administer parts of theirtax systems and other public responsibilities. The foreign exchange constraint then is important, as the price ofthese services can be very high.

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A significant source of domestic public resources may derive from the project itself. Thisis particularly important in the case of projects producing private goods, such as in the powersector. Efficient pricing, equal to some measure of marginal costs, is the least which should beaimed for, again with the caveat about distributional effects. Pricing above marginal cost mayimprove the affordability of the project with acceptable loss of consumer surplus, and can thusbe optimal. A more lucrative method of obtaining government revenue, as well as a moresocially efficient method, is to use two-part tariffs. These can be adjusted to account fordistributional needs," but the administrative costs of implementation may be high.

(d) Some Implications for appraisal

It is difficult at the appraisal stage to tell which complementary macro- and microeconomicpolicies/reforms will be undertaken by the government, or how effective they will be in closingthe resource gaps discussed. Possible future disagreements over appropriate policy changes andimperfect knowledge of the adjustment process of the economy contribute to this uncertainty.We have argued in the previous section that uncertainty should be taken into consideration inthe evaluation of projects, but in the case of contingent policy responses, it may be sufficientto study the prospects under a number of different scenarios to get a general idea.

This has been done in the Arun M project in Nepal, where the feasibility of the projectunder favorable policy responses, including agricultural price reform, privatization andrestructuring of some industries, and rationalization of irrigation projects, has been analyzed.If the project is found to be unaffordable or affordable In all scenarios, the decision is easy.However, if the outcomes are mixed, the project may well become a country issue, dominatingpolicy discussions and choices. It may be that a less controversial (set of) project(s), with asimilar rate of return, exists, and should be adopted ahead of the original proposal. Thissuggests the need for early rudimentary calculations of the affordability of large projects toestablish the net worth of further appraisal work.

(e) Debt sustainability and real exchange rate movements

Suppose that the domestic costs of a large project constitute only a minor portion of thetotal resource requirements. If the project is financed by a foreign gift there is certainly noaffordability question. The more likely situation is that it is financed by an external loan(assuming foreign exchange reserves are too low to pay the total cost). The project is thenfeasible if the debt incurred is sustainable.

This requires a suitably large and consistent flow of foreign exchange into thegovernment's coffers. If the project output is tradable, the only constraints on affordability arethe project's productivity, the world price of the output, and the tax capacity of the government.

2\ An example is the life-line telephone rate used for low income users in the US. A low monthly rentalcharge is imposed, with a high marginal price, while more affluent users are charged a high monthly fee andface a low (often zero) charge per call.

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If the output is non-tradable, as is the case with many large projects (e.g. power, transport, etc.)the growth of the economy, and in particular of net exports, must be sufficiently reliable.

These observations raise no new issues in project selection. More interestingmacroeconomic phenomena occur when we allow real exchange rate movements, which arelikely to occur when the project requires both non-tradable and tradable inputs. These relativeprice movements can lead to budgetary problems for the government as it tries to pay off thedebt incurred. It is necessary to distinguish between these budgetary problems - i.e. the effecton the government's access to real resources -, and the effects of real exchange rate movementson total real national income. It is argued that the first is more important for debt sustainabilityreasons than the second, except perhaps when the nominal exchange rate is flexible.

Suppose a large project is financed by an external loan. This is used by the governmentto purchase tradable and non-tradable inputs, which we assume to be required in fixedproportions. The increased demands cause the relative price of non-tradable to increase and areal appreciation occurs. For the original amount of dollars, the government is able to affordless inputs than planned at the original prices. Of course, the transfer of real resources to thecountry as a whole is left unchanged if we assume a fixed nominal exchange rate, but some ofthis is diverted to the producers of non-tradables away from the government.

This is not a problem in itself - relative prices should change in response to demandincreases to ensure efficient allocation. However, it is important that the government recognizethe impact of the real exchange rate appreciation on the size of its effective claims to resourcesentailed in the initial loan.

The effect on the budgetary position may be amplified when the project is nearingcompletion and repayments are to be made. Corresponding to the reduction in demand forproject inputs, ceteris paribus, the relative price of non-tradables will fall. This realdepreciation means that the government must save more real resources than otherwise to financeits debt obligations. Again, assuming a fixed nominal exchange rate, the country as a wholedoes not face higher repayments than foreseen. However the government is required to raisemore public revenue from the private sector than would have been necessary if the real exchangerate effects did not eventuate.

The real exchange rate effects depend crucially on the size of the component of non-tradable inputs to the project. For instance, if all inputs are tradable, relative price movementswill be much smaller, and the effect on affordability can be ignored." However, this extremesituation is not often observed.

&\ There will still be some impact upon the real exchange rate as income generated from the project is spent byprivate individuals partially on non-tradables. However, this is likely to be later in the life of the project, andcould conceivably lower the government's debt burden if the real appreciation occurs during the repaymentperiod.

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Note once more that the real exchange rate effects are only problematic in a budgetarysense. The initial loss to the government is a gain to the producers of non-tradables, while theextra repayments by the government must come from taxes. If taxes are lump-sum and costless,there is no net effect. But of course, this is not the case, and the social costs of debt financingare higher than the nominal interest rate on the loan would suggest. Thus, the internal transferproblem gives real exchange rate movements the potential to constrain the affordability of largeprojects.

A flexible nominal exchange rate system can introduce real effects on total national incomeas well as exacerbating the budgetary effects discussed above. The initial dollar denominatedloan is used to purchase some non-tradables, so the demand for the domestic currency increasescausing a nominal appreciation. 36 As well as reducing the real value of resources available tothe government, this reduces the real value of the loan itself, so the net transfer is smaller thanoriginally intended. Similarly, at the time of repayment, ceteris paribus, the demand (by thegovernment) for dollars increases, causing a nominal depreciation. This increases the real value,to the country as a whole, of the repayments.

These arguments support the acceptance of small projects ahead of large, only to the extentthat small projects have less effect on the real exchange rate. Certainly a single small projectwould not result in large movements of relative prices of tradables and non-tradables, but thequestion is whether a group of small projects would have less effect than a single large one.

It could be argued that different small projects will use different kinds of non-tradableinputs, so that the effect on the price of non-tradables as a group will be small. This suggestionis not particularly persuasive. A more compelling argument in favor of small projects is thatif they are undertaken sequentially, the borrowing requirements at each stage will be small, andhence the effects on the real exchange rate minimal. Such a sequencing has the additionalattraction that effective nominal interest rates from commercial banks may be lower due to themoral hazard problem associated with sovereign debt.

(III) Macroeconomic desirability

Once it has been established that the project is affordable, its macroeconomic desirabilitymust be addressed. The desirability or otherwise of some of the individual methods of closinginternal and external gaps has been alluded to above. An alternative perspective is to try towork out shadow prices of public revenue and foreign exchange, suitably adjusted formacroeconomic constraints. We examine in some detail the budget position of the government;similar considerations apply to the current account and the value of foreign exchange.

L\ Clearly, if there is a dual exchange rate system the effects will not be as simple.

\ In fact, it could be argued that a careful sequencing will mean that any induced real exchange ratemovements cancel out; the real depreciation associated with the repayment of one loan would counter-balancethe real appreciation resulting from the next injection of foreign capital.

41

It has become commonplace in the Bank to value public and private income equally.Originally, Little and Mirrees (1974) advocated placing a relatively high shadow value on publicrevenue due to the perceived paucity of public investment, particularly in public goods. On theother hand, if we assume that the government is following an optimal public expenditure plan,the value of a marginal increase in public investment is the same as that of a marginal increasein private expenditure (on investment or consumption). It is debatable whether this is the casein developing countries; some would say that public investment is still sub-optimal, while otherscharge that much public expenditure is (close to) pure waste. In the first case, the relativeshadow price of public to private income is more than one, while in the second it is less thanone, and possibly negative.

In any event, when a project accounts for a sizable share of the total capital budget, evenif the mix and level of public investment is optimal initially, arguments based on marginalanalysis do not hold. Unless the project is financed by a foreign gift and there are no co-financing requirements, extra taxes will need to be raised. The concept of the shadow price ofpublic funds then measures the net economic cost of raising the required additional revenue.These costs include both administrative and dead-weight loss or excess burden costs. In a partialequilibrium context, the latter increases (approximately) quadratically with the size of the taxrate, so if large amounts of tax revenue are needed, this cost may be very high. Pooradministration systems and narrow tax bases in many developing countries, make it highly likelythat the shadow cost of public revenue will be significant.

(a) Raising extra revenue

Squire (1989) has made special note of the necessity to shadow price public revenue whenlump-sum taxes are unavailable. Stern (1987) and Ahmad and Stern (1987) present thenecessary theory for estimating this cost of taxation, and illustrate with an example of tax reformin India. A marginal increase in revenue will result in different social costs depending on thetax instrument used (unless taxes are initially set at optimal levels). For a given level andconfiguration of public expenditures, Appendix 3 presents an outline of the relevantmethodology.

(b) Expenditure reductions

Of course, an alternative means of increasing national savings is to cut governmentspending, as discussed above. For instance, in the appraisal of Sri Lanka's Major IrrigationRehabilitation Project," it was reported that "[i]n view of severe constraints on the availabilityof local funds, the project could not be financed earlier than 1985" and that "...theGovernment's investment program is being curtailed substantially."

In general such a curtailment could imply either discontinuing wasteful policies andprojects, or dropping or scaling down otherwise socially valuable ones. If the first approach isfeasible, the question arises as to why the wasteful expenditures were not cut beforehand. Their

2g\ World Bank, Staff Appraisal Repot No. 5231-CE (1984).

42

presence may well be thought of as a fixed cost of the form of government - democratic,dictatorial, or whatever.

If previously successful projects are to be eliminated, then the total economic cost willtypically be greater than the financing required for the large project. This is because it is verylikely that some of the projects to be cut will be generating high social returns. In this case, thecosts saved on these projects are less than the benefits foregone when they are discontinued.Another way of seeing this is to suppose that the project is to earn a return of 10%. If tofinance it some smaller projects with returns of 15-20% are sacrificed, the net economic costper rupee saved is higher than one. Again the shadow price of public funds is higher than one.This is especially important with very large projects, as it will be very hard in this case to avoidcutting some small projects and programs with quite high social returns.

In the Sri Lankan case mentioned above, "assurances" were given by the government that"...adequate and timely budgetary provisions for the implementation of the project..." would bemade. As it turns out, public expenditures associated with the deteriorating security situationnow consumes 4% of GDP and the fiscal position of the government has become even tighterthan in 1984. One means of lowering the Colombo government's exposure to recurrent costshas been to allocate responsibility for operation and management to Farmers' Organizations, withthe hope that this may also enhance the efficiency of the maintenance of the system."However, this cost saving was balanced by a revenue loss, as politically unpopular water chargeshad to be discontinued to compensate the farmers (although fertilizer and agro-chemical subsidieshave also been withdrawn).

We have established that when appraising large projects, public funds are more valuablethan private funds, if administratively costly and distortionary revenue instruments must be used.It follows immediately that current Bank practice may well be unduly biased in favor of largeprojects, since the social costs of financing them are underestimated. As noted above, theshadow price of public funds will not usually be constant over the range of budgetary positions,but it will almost certainly be greater than one over the whole range. Thus, some average value,based on existing studies of a country's tax system, would be an improvement over currentpractice.

On this point it could be argued that the expense associated with the necessary researchinto the tax system would not be justified for the appraisal of a single project. This may be truefor small projects, but if the government is about to commit 25% of its capital expenditure toa particular program (consisting either of a single large project or a series of smaller ones), theadditional research may be warranted.

n\ While the performance of contract work undertaken by the farmers is satisfactory, delays are reportedlymore frequent.

43

(IV) Sectoral Issues

If a large project increases real incomes significantly, sectoral macroeconomic effects maybe of concern. This is especially true for industrial projects, such as large scale miningventures. The literature on Dutch Disease has highlighted some of the consequences of resourcediscoveries for other sectors of the economy, and to the extent that a large project impactsinitially on one sector, the same issues are relevant here.

(a) Is Dutch Disease a problem?

As stressed by Neary and van WUnbergen (1986), consequences of exogenous incomeshocks (in this case due to the project) are not necessarily welfare decreasing, and thus may notrequire any special policy changes. If labor and capital markets work well, deindustrializationand real exchange rate appreciation "represent responses which are necessary if the economy isto enjoy the fruits of its increased wealth."4

Accommodating macro policies are required for the same reasons as usual - if marketimperfections exist, or if the distribution of income is not in line with the government's desires.In the short run, these problems are manifest as "transitional adjustment difficulties", which mayrequire temporary support for the declining sector and/or modified trade policies to protect thecurrent account (if this is thought necessary) in response to a real appreciation. 1 In the longerterm, learning-by-doing externalities may require more permanent subsidies, especially if capitalmarket imperfections exist. If some prices, especially wages, are sticky, accommodatingmonetary policy may be required to effect real relative price changes.

The impact of a real appreciation on the affordability of the project should be noted. Therelative price change feeds directly into the project's costs, depending on the time path ofexpenditures (e.g. if most foreign inputs are required at an early stage) and the speed ofappreciation. If all foreign costs are incurred very early, but the effects of financing on the realexchange rate are deferred, the impact on the affordability of the project is negligible.However, the gestation time of large projects can be of the order of five to ten years, while realexchange rate swings occur over months, so the inflation of foreign costs could be significantin widening the external gap.

(b) Do sectoral Imbalances matter for World Bank projects?

It should be noted that the real resource movement effects may be less significant for manylarge Bank projects than suggested by the standard theory. In particular, if the project producesan input into many other production process, then output in those sectors may expand rather thancontract. While the spending effect will still result in a real appreciation, the resource

4Q\ Neary and van Wijnbergen, page 41.

41l In the standard Dutch Disease model, the real appreciation results from the change in relative prices oftradables and non-tradables.

44

movement effect may be quite unimportant. If it is the reallocation of factors of production thatleads to problems in the standard analysis, there may then be little reason to worry about the"disease". This applies, for instance, to many power, transport, and communications projects.If firms were previously quantity constrained on these input markets, the project may well leadto their expansion. Clearly, when the output of the project is an export good, the resourcemovement effect may be more problematic.

Exchange rate policy may have different real effects on the behavior of the economy inresponse to the large project. Briefly, under a fixed exchange rate system, domestic inflationmay rise to effect a real appreciation, if the demand for non-tradables increases relative to thatof tradables. If this is gradual, the real effects of the income increase will be delayed. This,coupled with the general political aversion to inflation, may imply the need for nominalappreciation of the currency.

On the other hand, when exchange rates are flexible and domestic prices sticky (say dueto government price controls), the required appreciation comes in terms of a decrease in thenominal exchange rate. In the short run, if there is overshooting, deflationary pressures couldcause an even greater decrease in the output of and employment in the deindustrializing sector.

These kinds of implications for monetary and exchange rate policy are welldocumented.42 However, direct use of orthodox Dutch Disease results is not recommended inthe present context, since, as discussed above, the nature of the large projects in which the Bankis involved is quite different to that of the standard theory. The effect of a project on therelative prices of tradables and non-tradables needs to be determined. This will depend on thekind of project (infrastructure, manufacturing, agricultural), the country's production set (i.e.input-output coefficients), and the flexibility of prices.

(V) Summary

Large scale projects can have macroeconomic impacts which should be factored intoappraisals. We have concentrated predominantly on the implications of large project financingfor the government's budget. Ignoring the benefit side of the decision, it is worthwhile initiallyto make rough calculations of the affordability of the project, given current government policy.If domestic or foreign resources are insufficient to finance the project (at current prices),complementary macro policies, such as tax increases, savings incentives, export enhancingprograms, etc. should be analyzed as to their effectiveness in closing these resource gaps. Ona microeconomic level, the identification of low return public expenditures (typically excessivesubsidies, loss making state-owned firms, etc.) may yield socially inexpensive revenue sources.

Fixed price techniques give a first indication of the affordability of a large project, butrelative price changes are almost inevitable, and from a macroeconomic affordability perspectivedeserve special attention. In particular, it has been suggested that real exchange rate movementsmay lead to budgetary problems insofar as they change the government's real cost of borrowing.

4\ See Corden (1984), and Neaty and van Wijnbergen (1986).

45

This need not be a problem if it is correctly accounted for, but the possibility requires explicitconsideration. If the country operates under a flexible exchange rate system, then over the lifeof the project movements in this rate can reduce the real value of a given external loan. Theseeffects suggest a sequence of small projects, where technologically feasible, is preferred to asingle large one.

The observation that budgetary constraints may be severe implies that public revenueshould often be valued higher than private revenue. That is, when calculating net benefits froma large project, the financing costs should be included, and a way of doing this is to shadowprice public income.

Finally, at a sectoral level, the possibility of Dutch Disease phenomena should beinvestigated. These are only problematic if disequilibrium resource allocations are costly.While the potential for such effects is acknowledged, it is argued that the infrastructural natureof typical Bank projects reduces the chance of orthodox Dutch Disease outcomes. Thesuggestions for appraisal performance that can be drawn from this section are summarized inTable m below.

46

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ТаЫеffi The �inpact of а large project опdeternцnants of its macroeconomic � `'o пdabilityапдdesirabil цy.

47

S. Mal remarks

Three areas have been identified which can be of concern in the appraisal of largeprojects. These pertain to the measurement of benefits when prices change, the impact ofuncertainty - distinguishing between risk issues and the implications of irreversibility for projectdesign - and finally, macroeconomic impacts and financing problems.

Measuring benerits from large projects generally requires information about both priceand income elasticities of demand. In particular, point estimates of demand are misufficientwhen market clearing prices change. While demand responses may be hard to determine, someof the rough techniques used in Bank appraisals, such as least alternative cost and projectedrevenue, implicitly assume parficular elasticities. If the assumption is sound, then it is likelythat better estimates can be made.

Before launching into an extensive estimation of project benefits, the analyst shouldcalculate shadow profits using pre- and post-project shadow prices. These calculations can givesufficient conditions for the rejection or acceptance of the project, in which case no furtheranalysis is needed. If this approach is inconclusive, explicit benefit estimation should beundertaken.

Simple consumer surplus benefit measures neglect the income effect. This can becorrected if income elasticities of demand are known, but it has been argued that it is likely tobe important only when income elasticities are sigmficant, and the output of the Ject isallocated by market clearing prices as opposed to some other form of rationing. Finally, thereis a strong case for the integration of distributional consequences of large projects at theappraisal stage, since income changes can be large and the large number of winners and losersmay prohibit explicit ex post compensation.

There are two distinct reasons for considering uncertainty in project evaluation - riskaversion and irreversibility. When a project is large, it may not be possible for the governmentto diversify the risks to insignificant levels. This is particularly true if the outcome of theproject is correlated with national income, as it is likely to be for some large infrasbuctiireprojects. There are two ways of incorporating risk premia into project appraisal: expectedvalues of net benefits can be adjusted to their certainty equivalent values, based on risk aversioncoefficients, and then aggregated using the risk free interest rate; or the expected values of netbenefits can be directly aggregated using a risk-adjusted interest rate. The second of thesemethods should be used with particular care, since in general, for large projects, the size anddirection of the interest rate adjustment is wnbiguous. In particular, it is not always correct toadd a couple of percentage points to the required rate of return to judge the desirability of theproject.

By committing large amounts of resources to a fixed but uncertain use, large projectssacrifice decision making flexibility. This is often necessary, due to economies of scale orminimum effective scale constraints. However, the cost associated with the loss of flexibilityover future decisions is real, and should be explicitly included in a cost-benefit analysis. One

48

method is that of robust planning or multi-objective programming. This technique allowsdecisions about design to be narrowed down to a set of projects that perform well in a varietyof different scenarios. However, in its simplest form, it suffers from the fact that probabilityweights are not used. Still, it is useful in discarding potential project designs which should beignored.

Alternatively, the theory of options values can be used to value the options which areforegone when a particular project design is chosen. The "design" includes investment timingdecisions, flexibility with respect to inputs (e.g. dual fuel power stations), and sequencingdecisions. The theory has not been applied extensively in practice (however, see Crousillat andMartzoukos (1991)), but in general, even if risk is fully diversifiable, the required rate of returnon an irreversible investment decision should be higher than the risk-free interest rate.Equivalently, as espoused by Crousillat and Martzoukos, a premium can be directly applied tothe project's NPV calculation.

Finally, a variety of macroeconomic requirements and Impacts of large projects havebeen addressed. These should be used as a check-list of macro issues that the project analystshould be aware of early in the appraisal stage, in order to avoid having the project pervadecountry level economic policy in a disruptive fashion. Specifically, we have looked at theaffordability of large projects, in terms of their impact on the government's budget, possiblecomplementary macro- and microeconomic policy reforms, and the affect of real exchange ratemovements on debt levels.

It is also necessary to examine the desirability of particular financing methods, and in ageneral framework this is possible with the use of shadow prices of public funds. Often, privateand public income is valued equally in Bank appraisals, but when large projects put heavypressure on the public budget, such practice is probably invalid. Further social costs may ariseif the project requires significant intersectoral reallocation of resources. If markets are notflexible, it is possible that Dutch Disease-like phenomena may arise, in which caseaccommodating fiscal and monetary policies may be required. However, it has been suggestedthat the orthodox results of resource booms may not be directly applicable to the case of manylarge projects, which tend to provide inputs to many other sectors.

A number of issues have not been dealt with. These include, for instance, the valuationof public goods (including environmental impacts), and the development of explicitmacroeconomic models. The latter would certainly be a fruitful source of further work, withimpacts on the issues raised in sections 2 and 3 of the paper. For instance, more detailedknowledge of the macro response of incomes to projects would improve the benefits estimatesof section 2. Similarly, the understanding of risk factors will be improved with better data onintersectoral linkages determining correlated risk. This will also allow the analyst to investigateDutch Disease issues more thoroughly.

It may have been instructive to pursue a comprehensive project appraisal throughout thepaper, identifying modifications at each stage. However, most projects do not exhibit all thepossible large-project characteristics we have alluded to, so it is hard to find a suitable example.On the other hand, it was found to be difficult to compare Bank evaluations across projects and

49

sectors due to what appeared to be a lack of unified explanation of the data and methods used.Certainly the incorporation of risk is rarely more extensive than simple sensitivity analysis, whilethere seems to be a tendency to treat macroeconomic variables as exogenous to the project.These approaches, and others identified in the paper, are reasonable for small project appraisal,but should not be automatically transposed to the large project case.

Starrett (1988) has lamented that "...it seems unreasonable to expect operational cookbookrecipes for project analysis anytime soon...",4 and the present author can all but agree withthis sentiment. However, it is hoped that this review has drawn attention to some possiblemistakes that can be made and how to avoid them, at least partially. To this effect, the paperconcludes with a discussion of some aspects of the economic appraisal of the Arun In powersector development proposal in Nepal.

Some suggestions for the extension of the appraisal of Arun M

Nepal's power sector development plans include large additions to the country's electricitygeneration capacity, significant drains on the government's budget, and the adoption ofengineering techniques and complementary institutional reforms with uncertain outcomes. TheArun M hydro-electric dam facility is the largest of a group of alternative developmentstrategies, significantly increasing generating capacity and the government's investment spending.The project could reverse Nepal's position as an importer of electric power from India to thatof an exporter. These initial observations suggest that it may be necessary to adopt thetechniques of project appraisal surveyed in this paper in a thorough economic analysis of theproject.

A fully fledged economic analysis has not yet been undertaken by the Bank, but extensivework has been carried out. While the present discussion is in no way an attempt at acomprehensive appraisal, based on the materials available to the author it is meant to suggestdirections in which the work already done could be extended or modified, in light of therecommendations of this paper.

Benefits

There is quite a lot of discussion in documents related to Arun about the increase inelectricity tariffs to accompany capacity extension. However, it is not clear that the proposedprices are considered to equal post-project shadow prices or not. There may be reasons for theprices used in revenue estimates and demand projections to differ from shadow prices (such asfinancing or distributional concerns), but it is shadow prices that are needed for estimation ofnet benefits. There does not appear to have been a "first stage" appraisal, as described in thispaper, calculating net benefits at pre- and post-project shadow prices. This would be a relativelycheap way to get some initial idea about the desirability of a more thorough economic analysis.

4l Epilog, page 293.

so

Some estimates of benefits, such as those used in the option value analysis (to be discussedbelow), attempt to estimate changes in areas under demand curves (that is, benefits) in terms ofthe savings the project would produce on previous energy imports or alternative productionmethods. If these savings on the cost of serving existing demand are small in comparison to anycost savings on induced domestic demand (that is, the difference between the cost of importingthe additional supply and the cost of producing it with the project technology), the benefitmeasure may be inaccurate.

Risk

Many review documents have noted that a systematic risk analysis of the Arun 11 projecthas not been carried out. There has been an option value analysis undertaken which reaches ahigh level of sophistication. It is noted however that, as mentioned in section 3 of this paper,the issues of risk and flexibility are conceptually distinct. While the options analysis is probablyadequate at this stage, there appears to be a paucity of rigorous risk analysis. The firstimprovement would be to use estimates of expected values in place of EGAP values. However,this is important for all Bank projects, and the size of Arun Il and the extensive nature of therisks associated with it call for the additional rigor of calculating certainty equivalent values oncethe simpler exercise has been completed.

One significant problem is the quantification of probabilities associated with institutionaland price reform: how likely is it that tariffs will be increased to the levels mandated?; willoperating cost increases negate the tariff reforms?; are tariff collections likely to improve ordeteriorate?; and can proposed loss reductions be expected to come about? The wide diversityof contingencies makes quantitative risk analysis difficult, but, at the same time, arguably moreimportant. Probabilities of successful institutional reform could be estimated by observing thebehavior of government agencies in other sectors of the economy.

Macroeconomics

The project represents a significant drain on government resources, and it has been notedthat there are no obvious candidates in the budget for compensating cuts. While tariff reformmay lead to significant cost recovery in later years, the initial investment resources must bemobilized. This makes it important that the real costs of government financing are included inthe analysis. The preferred method of doing so is to calculate a measure of the shadow cost ofpublic funds, as discussed in section 4.

A number of discussion documents have alluded to the possibility of crowding out of otherinvestment projects in the Nepalese economy due to the large resource cost of the Arun mIproject. This means that the shadow cost of capital should not be taken to be the standard rate.This issue can be incorporated in the *first stage" appraisal outlined in section 2 by using thestandard accounting rate of interest as the pre-project shadow cost of capital, and estimating theaccounting rate of interest after the project to use in the post-project shadow profit calculation.

51

Bibliography

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Ap=edix 1Page 1

Appendices

Appendix 1: Distributional weights

If we let b? denote the vector of income elasticities of demand for individual i , then thenet benefit of the project to that individual is

B, = p1.Aq- !Ap.Aq,+I(Ap.bO)Am, (9)

using equation (2). Total net benefits are then the welfare weighted sum of the B,

k

B OjE BI (10)L*1

where O are the weights. Even the roughest disaggregation of demand changes and incomeelasticities between income groups will be worthwhile when either incomes are initially verydisparate, or when the net benefits (or costs) of the project are expected to be distributedunevenly (or both).

The formula incorporating distributional concerns is only valid if the distribution of incomedoes not change significantly as a result of the project, or equivalently, if the welfare weightsare approximately constant. If the size and distribution of income changes significantly, thenmore complex measures are necessary; clearly, if the effect of a project is to make the very richvery poor, and vice versa, then it is harder to decide what should determine the relativeweighting. Such measures are discussed in Hammond (1983) building on the work of Sen(1976).

55

Andix 2Page 1

Appendix 2: Shadow price of public funds

If producer prices are fixed then the social marginal cost of public funds from acommodity tax on good i is"

ah (11)

where xt is the demand for good i of household h , X is aggregate demand for good i, tsis the tax on good i , and Ph are the welfare weights.' This is the loss in terms of socialwelfare incurred in the raising of a unit of revenue, so the total cost of raising the necessarylocal finance, R , from a tax on good i is thus

MRQ) =fR )/ %r)dr (12)

This must be explicitly included as a cost in the net benefit calculation. The data requirementsfor this calculation may be excessive, but A may be approximated by

AA(R) - Ir.R (13)

where X, is an average value of X1 over the range of integration. A rough approximation tothis value may be found by calculating

i XO) + AA(R) (14)2

Note that it will normally not be optimal to use a single tax instrument such as k- to raise allthe required revenue, so that equation (13) will overestimate the social cost if a suitable tax mixis used.

M\ Ahmad and Stern (1987), equation 11-26.

4\ Ahmad and Stem (1987) show how this formula can be expressed in terms of data friendly* householdconsumption shares and elasticities. See their equation (11-27).

Appendix 3: World Bank Projects Discussed In the Text

EXp. Project 81e as a 1 ofBorrower Project Objectives Project Description En GOP INu Kli. REV EP

CINA ERTAN NTDRGELECTRIC 1> provide additionat generation cap~city to the The projOct will inc&ude: (a) preparatory worka; 14.9% 0.7 1.7 63.8 3.7 3.61991 PROJECT power system in Sichuan Province; 2) assist in the (b) construction of a parabotic. dmåble curvature

transfer of modern power technology and in the arch dm (240 m high) across the atong River tog-Loan Amwunt: $380.0 million introc~ction of off icient dam construction methoda; ether with an underground powerhouse clex, a togProject Costa $2,487.0 mittain 3) contribute to further laprovements In the coweyanc system, and appurtenant work d and struc-

analysis of enwironmntal and ecologicat iapacts of tures; (c) provision and installation of Mix 500-iNhydroelectric rasource devalopmnt; 4) enhance the generating unita and associated euipmnt; (d) ro-Institutionet devopment of the Ertan uydroetectric settement of about 30.000 people; (e> an environ-Development Corporation (ENBC); and 5) provide mentat amnagement program nd science staton; (f)technical assistance in project design and consuttant's services for engineering, proctrement,implementatlon. management of construttion, and prepratlon of

future poer projects; (g> studies of pamer pricingand pwer and reservoir operation; and (h) stren-Othening ENDC's organisatimn, technical assistanceand staff training, together with retated eqipmentand accessories.

CINA SIaKOU MROELECTRIC 1) develop a major hydro sit* to serve as T 7he project coprises the folieing: a> prepartory 15% 0.4 1.0 15.0 1.7 1-.61986 PROJECT peaking station in the East China Grid; 2) provide worke coprising access roads, constructfon colony,

technotogy to sped targ dm construction; 3) retocation of a main highay, a bridge acro s theLoan Amunt: $140.0 miitin promate integration by linking the East China and river, construction power lines, etc.; (b) cons-Project Costa $1,087.8 million Funjian system.; 4) provide training in management truction of a concrete gravity dam (101 m high), a

of internatignal contracts for targe civil worka spittway, a powerhouse, a 3-stage nvigation tockand in international management. and appårtenant works; (c> provision and instatt-

ation of seven 200 NU generating sets and associatedelectrical system inctuding a 500 kV step-up sub-station; (d> construction of a 500 kV sinle-circuittransmission line, about 560 km long, fre Shuikaoto Banghou, including necessary eaip~nt In asubstation at Jiufta; () resttement of about -aL>63,000 people and agriculturat devem~nt for the in 13reconstruction of thoir production systems andcomities; (f0 consutting services for engineering

Exp. Project Size as a X ofBorrower Project Objectives Project Description ERR iDP t1V KFL REV EXP

and construction management; (9) studies of (1) co-ordinated operation of hydroelectric plants in theFujian and East China grids and related systemImprovements; and (2) power system controls andtoad dispatching systems in Fujian and East China;and (h) training.

CHINA YANTAN HYDROELECTRIC Seeks to support economic growth in South China The project would comprise: (a) construction of a 121 0.4 1.8 14.2 1.6 t.51986 PROJECT through the cascade development of the Hongsul 110 a high concrete gravity dam, a eitway. a

River. powerhouse and a ship lift; (b) provision andLoan Amount: $52.0 million installation of four generating units of 275 InProject Cost: $1,033.1 million each; (c) construction of two single circuits of

500 kV transmission lines and three associatedsubstations; Cd) provision of about 160 man-monthsof consulting services for construction management;and (e) training for Guangxi Electric Power Bureau(GEPS) staff and upgrading of GEPS facilities, andtraining for Government officials in financialmanagement and planning and utility accounting

practices.

CHINA LUBUGE HYDROELECTRIC 1) provide generating capacity and energy to the The project mit comprise: (a) construction of a 12% 0.3 0.8 50.5 1.3 1.21984 PROJECT Yunnan power grid; 2) introduce technology in rockfitt dam about 100 a high, a spillway system,

construction of dams, tunnels and underground an intake structure, a 9.4 km headrace tunnel, aLoan Amount: $145.4 million power houses; 3) Introduce International surge tank, two penstoc shafts with steel lining,Project Cost: $811.7 million Coopetitive Bidding (ICS) for procurement of an underground powerhouse taflrace tunnet, with a

civil works and associated technical assistance; switchyard end provision of equipment therefore;

4) address financial and auditing issues; 5) intro- (b) provision and installation of three generating.duce financial forecasting; 6) promote cofinancing units of 150 NW each with provision for a fourthwith bilateral and export credit sources; and unit; (c) provision and construction of two 220 kV

7) provide staff training. single circuit transmission lines of about 184 tmeach from Lubuge to Kunming and one 22 kV single

O

Exp. Project Size as a % of

Borrower Project objectives Project Description ERR GDP IRV KFL REV EXP

circuit transmission line of about 129 km fromLubuge to Qujing with associated substations; (d)consultant services for a Special Board of Cons-uttants (SBC) and construction management andsupervision; and Ce) a training program.

HONDURAS THIRD PORT PROJECT 1) provide suitable facilities at Puerto Castilta the project wilt consist of: (a) construction of a 8% 2.3 9.5 .. 13.1 13.2

1977 and at San Lorenzo for the efficient handling of wharf at Puerto Castilla, 450 m long with alongside

new export traffic; 2) carry out a channet depth depth of 10.5 m below mean low water spring tide;

Loan Amount: $17.0 million study for San Lorenzo; and 3) to train Empresc one transit shed, one warehouse, two open-sided

Project Cost: $29.9 mition Mactonal Portuaria (ESP) staff in container tanber sheds, office and maintenance butIding, one

operations, palm oil storage tank, and miscellaneous structures.(b) extension of the pier at San Lorenzo to providean additional berth 145 m tong with alongside depthof 7.5 a below mean low water spring tide, construc-t ion of one sugar storage shed, and two molasses

tanks 3,800 ton capacity each; (c) consultant IoAservices for detailed engineering and supervisionof the construction for Puerto Castilla and San

Lorenzo; and (d) technical assistance for a studyto determine the optimal depth of the access channetfor San Lorenzo; and a manual detailing the pro-cedures and documentation for container operations.and training EMP's staff in the mnagement and oper-ation of the container berth and consolidation depotat Puerto Cortes.

HONDURAS EL CAJON POWER PROJECT 1) increase the generating capacity of Express The project would consist of: (a) a concrete dam 9% 19.4 79.1 191 130 110

1980 Mactonal de Energia Electrica (ENEE) to be able to with a maximm height of 225 a and a crest length

meet the demand for electricity projected for the of 382 m; (b) three bottom outlets each with a

Loan Amountt $125.0 million period beyond 1986 and reduce fuel consmption in capacity of 630 m3/s including a crest spillway;Project Cost: $493.2 million thermal generating plants; 2) contribute to the (c) an intake structure and two inclined pressure

QQ10o0

on

Exp. Project Size as a % ofBorrower Project Objectives Project Description ERR GDP INV KFL REV EXP

control of floods In the Suia Valley; 3) regulate shafts wilt be included In addition to fourthe flow of the Numuya River downstream of the dam Francis turbines with their draft tubes andthus enabling future irrigation projects there; tatlrace tunnels.and 4) strengthen ENEE's organization and manage*ment by on-the-job training of its staff.

SRI LANKA MAJOR IRRIGATION to Increase agricultural production and to Iatro- The project would: (a) rehabilitate existing Irri- 16% 0.7 3.6 7.6 3.0 1.91984 PENABILITATION PROJECT duce an effective program through 1) the rehab- gation systems serving a total area of about 46,000

ititation of the system for optimal utilization ha; (b) Introduce an integrated Management ProgramLoan Amount: $17.0 million of available water; and 2) support for the Program to ensure proper operation and maintenance of theProject Cost: $43.2 million for Integrated Management of Major Irrigation systems and ditribution of Irrigation supplies;

System (INMAS) at the national level. (c) strengthen support services provided by variousGovernment agencies; and (d) make provisions formonitoring and evaluation of project execution andperformance. tA

SRI LANKA NATIONAL IRRIGATION to protect and increase agricultural production and This seven-year project would include: (a) rehab- 311 0.6 2.8 14.9 2.9 2.21991 REHABILITATION PROJECT incomes and to raise the standard of living of the Ilitation and Improvement of about 1.000 minor and

beneficiaries through rehabilitation and improved 60 medium/major i#. igation schemes covering aboutLoan Amount: $29.6 million operation and maintenance of existing irrigation 37,500 ha; (b) establishment of farmer organizationsProject Cost: $49.8 million schemes. Subsidiary objectives are to: 1) upgrade and introduction of Improved operation and maint-

the skills of staff of implementing agencies and enance practices in all rehabilitation schemes;the farmers; and 2) establish viable farmer organ- (c) training of staff of implementing agencies andizations for managing the rehabilitation schemes. farmers; (d) execution of environmental protection

works and studies; () establishment of three newsupport units in the Irrigation Department and exe-cution of hydrotogical and socio-econanic studies;(f) provision of consultants' services for projectplanning, implementation, and impact assessment;and (g) procurement of vehicles and equipment.

odo to

:li

Exp. Project Size as a X of

Borrower Project Objectives Project Description ERR GDP INV KFL REV EXP

BANGLADESH JAMUMA MULTIPURPOSE to stimulate economic growth by providing land The project consists of: (a) construction of a 9.2% 2.8 23 67 25 19

1989 BRIDGE PROJECT transport of electricity, passenger and freight bridge, about 4.7 km tong, to carry a power inter-

traffic, and, potentially. natural gas and tele- connector, a road, and, potentially a gas pipeline

Loan Amount: $110.0 mill . comunications, between the Northwest quadrant and and telecommunications link; (b) construction of

Project Cost: $560.0 million the Eastern half of the country in a cost-effective river training works consisting of two guide bnds,

fashion. each about 2.5 km tong, comptemented by two stren-thened points upstream for protection of the bridge

abutments and prevention of outflanking; Cc) cons-

truction of the bridge approaches which consists

of a 16 km tong eastern approach road and a 14 km

tong western approach road; (d) technical assist-

ance and training which would include project mana-

gement, institution-buf(dfng, training in operation

and maintenance, sector studies, regional studies

and environmental enhancement studies.

8NEPAL ARUN III (ACCESS ROAD/ 1) help meet the forecast demand for electricity The main features of the project are: (a) a 192 km 14% 27 147 272 268 132

1W90 HYDROELECTRIC) PROJECT in Nepat up to FY2007; 2) help strengthen the Nepat access road; (b) a 67 m concrete gravity dam with

Electricity Authority's (NEA) institutional via- gated spitlway; (c) 4 desanding caverns with WI/L

Loan Amount: $240.0 million bility; and 3) facilitate Nepal entering into a approximately 17/28/110 m each; (d) a headrace

Project Cost: $800.0 million bulk sales agreement with India and initiating tunnel (11.4 km tong); (e) a power cavern for

large scale power exports to India. 6 x 67 KU Patton turbines; (f) transmission/sut-

stations to link the project with the Nepali and

Indian national grids; (g) an action plan to iapte-

ment the recomendations of the projects environ-

mentat assessment; and (h) infrastructure and tech-nical assistance to support the setting up of the

Makatu-Barun National Park and Conservation Area

Notes: GDP a Gross Domestic Product, INV = Gross Domestic Investment

KFL a Net Capital Inflows, REV a Government Revenue less Grants

EXP a Total Governaent Expenditures, ERR a Expected Economic Rate of Return

ou

ASIA REGION DISCISSION PAPERS 1/ (Continued)

T[it Auto Da.In Oriainator

1DP42 An Analysis of the Nature of Unemployment W.T. Dickensin Sri Lanka and K. Lang July 1989 R. Zagha (80433)

IDP44 Assisting Poor Rural Areas ThroughGroundwater Irrigation F. Kahnert August 1989 C. Chamberlin (81409)

IDP51 Educational Development In Asia: AComparative Study Focussing on Cost J-P. Tan andand Financing Issues A. Mingat October 1989 J*P. Tan (81408)

IDP52 Chinese Reforms, Inflation and theAllocation of Investment in aSocialist Economy 0. Yenal October 1989 0. Yenal (81415)

IDP83 Public Policy to Promote Industrialize-tion: The Experience of the East AsianNICe and Lessons for Thailand D. Dollar May 1990 D. Dollar (80518)

IDP65 A Study of the Poor In Sri Lanka C. Rouse June 1990 Y. Huang (80434)

IDP88 Health Sector Financing in Asia C. Griffin August 1990 J-P. Tan (81408)

IDP74 A Case Study of a Gradual Approach toEconomic Reform: The Viet NamExperience of 1985-88 Z. Drabek September 1990 Z. Drabek (80504)

IDP85 On Estimating Inadequacy of EnergyIntakes: Revealed Food ConsumptionBehavior versus Nutritional Norms B.S. Minhas September 1990 S. Jayanthl (81419)

IDP88 Asia Region Seminar on PolicyChallenges In India October 1990 C. Chamberlin (81409)

IDP93 Parametric Population Projection andIts Usefulness for Policy Analysis W. Sanderson April 1991 J-P. Tan (81408)

IDP96 A Review of Korea's Trade Pattern D.M. Leipzigerand S.Y. Song March 1991 D. Leipziger (81388)

1DP97 Sustainability as IntergenerationalEquity: The Challenge to EconomicThought and Practice R.B. Norgeard June 1991 F. Johansen (81410)

1DP99 Housing Prices, Affordability, andGovernment Policy in Korea K-H. Kim July 1991 D. LelpAiger (81388)

IDP101 Lessons from Experience with WageFlexibility in Asia 1. Nabi August 1991 1. Nabi (80514)

jl Papers still available upon request. Asia Series discontinued following December 1. 1991 restructuring of the Region.

Note: Extra copies may be obtained from the Asia Information Service Center.