Part II.
Principles and Techniques for Conducting Economic Analyses

Part II contains a more technical discussion of the principles and techniques of economic analysis that can be used in developing the measures of value and project worth illustrated in the previous chapter (see figure II. 1). One chapter is devoted to each of the four main steps in the analysis process. Thus, chapter 4 deals with identification and specification of inputs and outputs. Chapter 5 deals with valuation of inputs and outputs. Chapter 6 deals with the analysis itself, i.e., how costs and benefits are compared to develop measures that can be used in answering the questions being addressed in the assessment. Chapter 7 deals with the treatment of uncertainty, i.e., how the analyst can produce information that will be useful to the decisionmaker in judging the relative merits of alternatives, taking uncertainty into account.

Figure II.1. Part II. Principles and techniques for conducting economic assessments.

4.
Identifying and Quantifying Inputs and Outputs

4.1 Introduction

One of the most critical and often most difficult steps in an economic analysis of a forestry project is the proper identification of project inputs and outputs. Estimates of direct inputs are generally the easiest to make. They include such items as labor, land, capital equipment, and miscellaneous supplies.

Estimates of the goods produced, such as fuelwood, timber, fodder, and so forth, generally also can be dealt with in a straightforward fashion. However, the environmental services side of forestry is more of a problem in terms of quantifying outputs. Often, these outputs have to be dealt with in a qualitative sense, e.g., in relation to watershed protection, preservation of biodiversity, aesthetic benefits, contribution to nature tourism, and so forth. Much of environmental forestry deals with avoiding losses; and such benefits can be difficult to estimate.

The present chapter lays out a general framework for identifying and quantifying the inputs and outputs associated with different kinds of forestry projects.

In all cases, the same general sequence of steps can be followed:

First, the analyst identifies project components that can be analyzed separately, i.e., those for which inputs and outputs reasonably can be separated and analyzed as separate entities in terms of cost and benefit relationships. Separating components is important for two reasons. First, it makes the analysis process more manageable; and second, as indicated in chapters 2 and 3, the conditions for financial and economic efficiency include the requirement that all separable components of a project need to have benefits at least equal to costs. (Financial and/or economic efficiency for the overall project could be increased by dropping those components where costs exceed benefits.) This step is discussed in section 4.2.

Second, the analyst identifies and quantifies the direct inputs and outputs that will enter into the financial analyses carried out to answer the relevant financial questions discussed in chapters 2 and 3. These are the inputs and outputs which will be bought or sold by project entities. In most cases, these inputs and outputs will be identified by major classes of project interested parties and, possibly, by other groupings of separable components identified in the previous step. This step is covered in sections 4.3 and 4.4.

Third, the analyst identifies and, to the extent possible, quantifies the nonmarket inputs and outputs which will be incorporated into the analyses needed to answer the economic efficiency questions.^[7] These include environmental services, protection functions, nontraded outputs for home consumption, etc. (see figure 4.1). This step is covered in sections 4.5 and 4.6.

4.2 Project Components: Separability and Interdependence

As mentioned above, the first step in identifying and quantifying inputs and outputs is to decide, on a preliminary basis at least, which project components can be treated as separable ones to be analyzed separately. Project components generally link together in one of three ways. First, there are horizontal linkages among components, i.e., components that are parallel to each other. For example, one could think of the activities of a thousand farm families participating in a tree planting project as one thousand components horizontally linked through the project. The question is whether they should be analyzed separately.

Second, there are vertically linked project components, where one activity or component depends directly on the other being there, e.g., tree planting component and an associated fertilizer component. Vertical components generally involve one-way dependence, e.g., fertilization only makes sense if the trees are there to fertilize; the logic of considering a fertilizer component depends on the trees being planted. The reverse is not the case. One should logically analyze the economics of tree growing without fertilizer and the economics of the tree growing with fertilizer, i.e., for the separable component of fertilization. The question is whether the additional cost for fertilizer is justified by the expected additional benefits (e.g., additional growth per unit time). If not, then that separable component should be eliminated.

Third, there are interdependencies with other projects that need to be considered. In most cases, this boils down to the question of whether or not the appropriate project boundaries have been identified and defined. For example, one needs to address the question of whether a tree plantation for an eventual industrial operation should be treated as. a separate project or as a component of a larger integrated industrial/forestry project.^[8] Other specific issues relate to the treatment of time-slice projects, i.e., projects that include only a part of an ongoing program, where final outputs will occur after termination of the project being analyzed. Concern needs to focus on carryover values and the question of definition of an appropriate project time-frame.

4.2.1 Horizontal project components

Forestry projects may involve two types of horizontal project components. One type is found in projects that are designed to produce multiple outputs, for example, sawnwood and plywood, or joint products such as timber, watershed or soil protection, and wildlife habitat. The second is related to project scale, i.e., where multiple, relatively independent, units producing the same output(s) are combined for administrative or other reasons into one project. Examples would be a community fuelwood plantation project that includes subunits or components in a number of independent communities, or a smallholder farm forestry project that involves support for establishment of numerous small independent plantations on private farms in a given region.^[9]

Figure 4.1. The central role of forests in our lives. (Source: Kenya Forestry Research Institute (KEFRI) Newsletter no. 2, May-June, 1987.

For both types - multiple outputs or multiple producers of the same output(s) - there will always be some inputs which are jointly required by all components. If nothing else, since they are encompassed in one project, they will have project administration inputs in common. But quite often they also will have other inputs in common, e.g., infrastructure, marketing services.

In some cases it is possible to undertake separate analyses of each component. A typical situation is where several parallel processing activities are included within the scope of the same project. For example, in a project designed to produce both plywood and sawnwood, the major input items can generally be assigned separately to the two activities (although they also will likely have some inputs in common, e.g., administration, some infrastructure).

In many other types of forestry projects with joint outputs, there is little scope for separate analyses of components, since most of the inputs required to produce the outputs are common to all of them. For example, an agroforestry project may produce wood, livestock fodder, and increased agricultural yields through soil protection. All three outputs (multiple uses of the trees planted) result from the same production system and inputs and are thus difficult, if not impossible, to separate from each other in terms of inputs.

In this latter case, the cost of adding on one purpose or output could be analyzed. For example, the extra cost of management and harvesting associated with improvement in the soil protection function of a plantation on a hillside aimed primarily at producing wood and wildlife habitat could be analyzed. But this would not be the same as analyzing the soil protection output as a separate horizontal component, since the additional costs required to obtain the soil protection would not be the same as the total costs for it if taken in isolation.

For a type of project that involves a number of relatively independent units producing the same outputs (such as the fuelwood plantation or smallholder agroforestry examples cited above), there is a different set of questions which is relevant in determining the value of looking at separable units. First, and foremost, is the question of data and information on which to base such separation. If, as is often the case, estimates of average or typical conditions are used for all the components because of lack of more detailed information, then separate analyses make little sense, since all components will have the same assumed conditions and thus the analysis of each will produce the same results (see box 4.1).

Whether or not separation of components makes sense, even if the information on which to base separation is available, depends on the nature of the particular project situation, the time and funds available for analysis, and the objectives and constraints faced by the relevant institutions involved in the project. It is seldom worthwhile to separate out all components. But it generally is worthwhile to look at some major classes of components in most types of forestry projects. Once the relevant separation has been determined (agreed upon) then the analyst can proceed to identify inputs and outputs by components, developing separate physical flow and unit value tables for each.

Some argue that as long as all inputs cannot be separately assigned to specific components there is little justification for separate analyses of components. The argument is that arbitrary assignment of joint costs is artificial and may lead to wrong decisions. The question is really one of extent. In cases where joint costs are significant in relation to separable costs (say around 25 percent or more of the total costs) separate analyses of components might lead to problems.

To summarize, for horizontally related project components, the analyst should explore the extent to which inputs and outputs (costs and benefits) can be separated in a meaningful way. If three-quarters or more of the costs required for a given component can be separated out, then it is probably worthwhile to analyze the component separately, using whatever information and judgements are available to allocate joint costs. If none of the project components appear to be reasonably separable in terms of their inputs, then inputs should merely be identified for the project as a whole.

The above relates to analysis of a given project which is already defined in scope. If the economic analysis is being used to help determine an appropriate project scope and content (i.e., in the project identification stage), then horizontal components and alternative combinations of components can be looked at in more detail.

4.2.2 Vertical project components and one-way dependence

Most forestry and forest industry projects also involve distinguishable vertical components or activities, where the output or result from one component is an input into another component in the project. For example, wood produced in plantations is an input into a processing activity, with both being part of a defined integrated forestry and forest industry project. The wood production and the processing are quite well-defined separate activities, if the wood has alternative uses or value other than in the project processing activities. (If it does not have other uses, then it should not be analyzed separately.) The main point to keep in mind when dealing with vertically related components is the concept of one-way dependence. This concept is illustrated with an example in box 4.2.

To summarize, inputs and outputs should be listed by separable vertical components so an analysis can be made of whether or not it makes economic sense to add successive components to the overall project (such as in the example of adding fertilizer to a plantation project). From these comments on horizontal and vertical components, it can be seen that for most projects there will be a number of intermediate physical flow tables needed for separable components for the entire project and not just one. Thus, if a project has two horizontally separable components and three vertically separable components for each of the two, it could have six separate flow tables, or one for each of the two horizontal components with three vertical components separated within each horizontal component. A total flow table would also be prepared, once the separable components have been analyzed.

4.2.3 Interdependencies with other projects

The above two types of relationships refer to interdependencies and separability of components within a given, defined project. Two additional types of relationships also have to be analyzed in order to properly identify inputs and outputs. The first relates to interdependencies between the project and other projects over time, i.e., in the case where the project merely represents a part of an ongoing activity or program. This type of project is called a time-slice project. The second is the type of interdependency which exists when the output of a given defined project only has one use and there is no practical way of estimating the value of the benefits of the project other than as an input into that use. These two types of interdependencies and their implications for input and output identification are discussed below, together with a special case of interdependency found in forestry, namely, the case of the allowable cut effect.

Time-slice projects and interdependencies over time. It is quite common in forestry to find projects that include only a given part of an ongoing program. These are called time-slice projects. Identification of costs and benefits in this type of project can be tricky, since care is needed to identify carryover values from previous activities (projects) which could be entered as costs in the new project and residual values associated with the new project which should be entered as benefits at the end of the new project. This task involves, among other things, distinguishing between sunk and nonsunk or recoverable costs. A sunk cost is an expenditure that already has been made and which cannot be recovered and thus should not enter into consideration in an analysis of appraisal of a project involving decisions about future expenditure or use of resources. With or without the project, the resources are used in the same way in the case of sunk costs. Thus, they involve no change in the project. These types of values are treated as follows:

INITIAL CARRY-OVER OR INHERITED COSTS AND TREATMENT OF SUNK COSTS. In a time-slice project, i.e., an investment in continuation or expansion of an ongoing operation, resources used in the present operation which also will be used in the continuation or time-slice project should be treated as follows according to the important general rule that analysis should be based on the difference with and without the project:

• if the resource would actually have been used in some other productive use in the absence of the proposed continuation project, then it must be included as an input in the economic appraisal of the continuation project and given some positive value;

• if the resource that will be used in the continuation project has no use other than for the proposed continuation project, then it should be included as an input but valued at zero in the economic analysis.

RESIDUAL VALUE AT THE END OF A PROJECT.^[10] Most projects have capital assets (land, buildings, equipment, etc.) which have differing lives. If some capital asset has a life that is longer than the project period chosen, i.e., the asset has some other use at the end of the project, then the value in that other use should be entered as a residual value or benefit at the end of the project. The argument is exactly the same as in the case of carry-over or inherited costs, except residual values are entered as benefits instead of costs, since when the project is terminated, it releases resources (or goods and services) which can be used in producing other consumption goods and services.

Residual values are common in financial analyses, since most often a purchase cost of an asset is entered into the accounts at the time it is paid for, and this purchase cost takes into account the expected stream of benefits foregone during the entire life of the asset, not merely for the time during which the asset will be used in the project. Thus, when a land purchase cost is entered in the financial analysis, it theoretically takes into account the value of the alternative benefits which the land could produce forever, not merely during the project time span. Thus, if the land has a use beyond the time span of the project (as it normally does) then a residual value should be entered at the end of the project to take into account the fact that the land will be sold or put into some other use when it is released from the project.

In an economic analysis, the theoretically correct way to enter the opportunity cost of land is to enter each year an annual value foregone by using it in the project in that year. In this case, since only the opportunity cost of the land during the time in which it is used in the project is entered into the accounts, there is no residual value to account for in the economic analysis. The same goes for other capital assets, again, however, only in a theoretical sense. In reality it is difficult to allow for annual values foregone or opportunity costs for most capital assets. Thus, commonly they are entered at full value at the time they are first committed to the project and, thus, a residual value is relevant. In terms of input identification, this means that an asset is entered once in the analysis as a cost in the year in which it is first committed to the project and then it is entered at the end of the project as a benefit and assigned a residual value which reflects the initial real cost for it plus the value of any improvements resulting from the project which have raised its real opportunity cost.

Residual value should not reflect any real value increase that would have taken place without the project. At the same time, if the real opportunity cost of an asset is increasing over the life of the project, then this should be reflected as a cost to the project in the unit value tables. This could happen, for example, when a new road increases the use value of surrounding land.

Time-slice projects can involve some serious problems in terms of identification and valuation of inputs and outputs. Such complications can be avoided by combining all directly interdependent activities (time-slices) and appraising them as one project. (The time-slice component of relevance can at the same time be analyzed separately in terms of its incremental costs and benefits, such as discussed earlier.)

Oftentimes, time-slice projects involve expenditure of funds for a few years of an ongoing program, with benefits occurring many years after the project is finished, in an administrative sense. The question arises as to how to handle these projects. The answer is clear. All costs required to obtain the output up to the point at which the output from the project occurs must be included in the economic analysis and the outputs must also be included, even if they occur a number of years after the administrative life of the project has terminated. In other words, the economic analysis deals with a project as including all the interrelated costs and benefits associated with achieving a given purpose or output. For example, if after official termination of an extension project, new farmers adopt the practices promoted by the project, then the net benefits can be attributed to the project.

Vertical interdependencies between separate projects or activities. In some cases, meaningful decisions about one project cannot be made separately from decisions regarding other projects. Thus, they need to be combined as components of one project. Specifically, the output of one project cannot be valued properly if it only has one use and that is an input into one other specific project or activity. This case relates closely to that discussed in section 4.2.2, except here a project has been proposed which is, in fact, not separable from certain other activities. In other words, in defining a project all major components or activities needed to make the project feasible have to be included (see box 4.3).

Since this problem really relates centrally to the problem of output valuation, it is discussed further in chapter 5. Here the subject is raised as a point to watch in defining the scope of a project.

Other interrelationships between various activities are relevant in defining the best project scope to meet a given objective or purpose. For example, several activities which have initially been defined as independent projects may be complementary in one of several ways. It may be that to take full advantage of such complementarities these activities should be combined into one project. For example, if the residues from a sawmilling project could be used in particleboard production, then consideration should be given to designing a project that includes both.

The special case of the “allowable cut effect” (ACE). Increasingly, foresters are being introduced to the concept of the ACE and its potential for raising rates of return from plantation projects. The basic concept is that if a country has an even flow sustained yield policy and has a lot of old growth or mature forest that is not adding any appreciable net increment, then by establishing a plantation and considering it as part of the old growth forest unit, the allowable cut of the old growth can immediately be increased, under the assumption that the plantation volume will become available to meet the even flow constraint in the future. The value of the increased volume of old growth harvested immediately is then attributed to the plantation project as a benefit. Since this benefit occurs immediately, rather than in the future when the plantation wood is merchantable, it tends to increase the present value of the net benefits of the project.

Whether or not this is an appropriate approach to attributing benefits depends directly on the assumptions made with regard to policies. If it is assumed that the even flow sustained yield policy will remain in effect, then the allowable cut effect would appear to be appropriate. This follows from application of the with and without concept. Without the plantation project, the additional wood would not be harvested now due to the even flow sustained yield policy constraint. If the allowable cut is an actual constraint (i.e., if there is demand at prevailing prices for more wood than is allowed each year), then with the project the additional old growth will be harvested. Thus, due to the project (and how it relates to policy) the additional wood is made available to society now and this is identified as the benefit due to the project (see box 4.4).

A commonly heard argument is the following: Since the wood could be obtained by merely changing the policy, how can the benefits be attributed to the project? The answer goes back to the basic assumptions underlying the measures of value used in the type of economic analysis discussed here. Opportunity costs as defined here relate to opportunities that actually are feasible, given the expected political and social environment which is expected to exist. Any policy could be changed. But the relevant question is: Will it be changed? If the even flow sustained yield policy is expected to remain in effect, then the ACE is a legitimate approach to benefit valuation, and the appropriate output to identify and enter into the physical flow table is the volume of old growth timber that will be harvested immediately due to the project. In a sense the ACE becomes a way of modifying or circumventing the even flow sustained yield policy impacts.

The even flow sustained yield policy and the associated ACE policy are two classic examples of policies that are not designed with maximum economic efficiency in mind. They are, therefore, prime candidates for a policy analysis, i.e., an analysis of the impacts of a given policy.

4.3 Identifying Inputs and Outputs: General Considerations

Once the analyst has determined what project components to separate for the analysis, the next step is to identify the inputs and outputs associated with those components. In the economic analysis, any effect which results in an increase in desired goods and services available for society is a positive effect and any effect which results in a reduction in quantity and/or quality of goods and services available for other uses (including environmental effects such as reduction in quality of water downstream) is a negative effect. Increases or decreases can relate to either or both quantity and quality of goods and services. The theoretical goal at this stage is to identify all the effects of the project on society. In practice, it is only possible to identify some of them due to lack of available information and lack of time and funds to generate additional information.

For the purposes of identification, a distinction is made between direct inputs and outputs and indirect effects. This is done more for convenience than for any conceptual or theoretical reasons. The terms are defined in relation to the financial analysis and the physical flow tables derived for use in estimating commercial profitability. In this context, direct inputs and outputs are those which enter into the financial analysis (i.e., are directly traded for money in a market) and indirect effects are all those other [often nonmarket] effects which are not considered in the financial analysis).

A point to note is that a given effect is defined here as being direct or indirect, depending on whether or not it is traded directly in the market in a particular project situation and environment. For example, in one case fuelwood may be traded in the market, while in another case it is produced and distributed free using some quota or other allocation mechanism. In the latter case, it would not have entered into financial accounts as a revenue (receipt). In the former it would have been considered in a financial analysis (see box 4.5).

Similarly on the input side, a given input can be direct or indirect in the context of the definitions, depending on whether or not it is paid for by the entity for which the financial analysis is carried out. For example, if the government provides and pays for certain roads required for a private plantation project, then the cost of such would not enter the financial analysis for the private entity for which the analysis is being done. It would still be an input into the project from the economic point of view and should be identified as such. If the private project built the road, even though it was fully paid for (subsidized) by the government, then it would have appeared in the financial analysis. (See chapter 6 where treatment of subsidies in the economic analysis is discussed.)

It does not matter whether an effect is labelled as direct or indirect. The distinction is made for convenience and to remind the analyst to look beyond the financial analysis for effects associated with a project.

With this in mind, the identification procedure suggested here, and discussed in the remainder of the chapter, is as follows:

1. Using the various technical studies available for the project, identify direct inputs and outputs. To the extent that separable project components have been identified, divide up the direct inputs and outputs by components. These can be listed in separate physical flow tables for components and added together at a later, summary stage in the analysis (see section 4.4).

2. Identify the indirect effects due to the project. List these by separable components, if possible, as indirect positive effects if they add to the aggregate quantity/quality of goods and services available for consumption, or as indirect negative effects if they involve reductions in the quantity/quality of goods and services available (see section 4.5).

In identifying both direct and indirect effects, it is important to distinguish them on the basis of what the resulting information will be used for in succeeding stages in the analysis. Thus, they should be divided and distinguished in categories which make sense from the point of view of valuation and in terms of the types of sensitivity tests which will be included in the analysis. Generally, project activities should not be listed as inputs, since values will normally be attached to the inputs required to carry out the activities and not the activities themselves.^[11] For example, it is not enough to identify land clearing as an input in a plantation project analysis.

Rather, land clearing can be a heading in the physical flow table, but under it should be listed requirements for various types of labor and supervision, machinery, tools, etc. Similarly, if at all possible, structures that will be constructed as part of the project should be broken down by the component inputs required to build them, and roads should be broken down by labor, machinery, and various materials required instead of just listed as roads. If this is not done, it becomes difficult at later stages to develop proper values, since it is the inputs which are required to build the roads which are shadow priced or valued.

4.4 Identifying Direct Inputs and Outputs

The direct inputs and outputs are generally the most important in terms of total project costs and benefits and are central to the economic as well as the financial analyses of a project. Commonly, the identification of such effects is done at the same time for both analyses. In most analyses of forestry projects, they are the only effects which have been given explicit consideration in terms of monetary values.

4.4.1 Direct inputs

The main source of information on direct inputs will be the engineering and other technical studies available at the time of the analysis. The various input categories for the project and for its separable components are defined and the relevant quantities are then entered in physical flow tables by each category and for the year(s) in which they are needed. The listing of inputs is done in a form that will facilitate valuation at a later stage. The types of main input categories which are relevant for most projects are shown in table 4.1. The table provides only a convenient checklist which will have to be expanded both in breadth and detail for particular cases.

Input categories shown in table 4.1 can be listed in a number of different ways by subcategories related to (1) phases of the project, (2) activities or components within phases, and (3) by foreign and domestic sources for each phase and activity. There may be three major phases

• project planning (preinvestment phase);

• investment phase (construction, i.e., fixed investment and preproduction capital costs); and

• implementation or production phase.

Activities within each phase will differ with the project being analyzed. Production activities (or components) will often include raw material production, processing activities, storage, sales and distribution. In many types of forestry projects it makes little sense to separate the investment phase from the production phase for the economic analysis. It is often preferable to treat the two together and distinguish activities such as site preparation, planting, crop maintenance and management inputs during the growing period and harvest and transport. The only general rule for establishing appropriate categories is that the analyst classify inputs in a way that makes sense in terms of the objective of the analysis, i.e., the derivation of the total value flow table and the measures of project worth. Some examples for specific projects are given later.

Table 4.1. Categories of direct inputs.^a

^a/ As mentioned in the text, depending on the situation, some of the listed inputs may be indirect instead of direct, e.g., in the case of infrastructure such as roads, community facilities, etc. It all depends on whether or not they are directly paid for by the project entity for which the financial analysis is being done.

^b/If raw materials, such as wood, are produced as part of the project itself, then the component input requirements are listed rather than the raw materials such as roundwood (see text).

If balance of payments effects are of particular concern to decisionmakers, then all inputs can be listed separately by domestic and foreign sources.

The amount of detail required for the tables depends on the stage in the planning process. During initial phases, when project identification, preparation and design is the main focus, the analyst may start with very general, rough estimates which can be used to make initial comparisons between alternative technologies, scales, locations, etc. As attention focuses on one alternative design, the detail required increases. When the alternative has been designed and prepared, the analyst may wish merely to summarize inputs by categories and activities or components with headings such as shown in table 4.1. The final appraisal document should not contain excessive details. Rather, reference can be made to the supporting studies, so the decisionmaker can find details, if so desired. The analyst should not be forced to wade through them to put the logic of the project and its appraisal clearly in perspective.

4.4.2 Direct outputs

Direct outputs can also be derived from the basic technical studies and from market studies which are a basic element for projects involving direct outputs.

There are two types of potentially direct project outputs which sometimes become difficult to identify properly. These can be labelled as cost savings and losses avoided. Some examples will illustrate them. Assume a project designed to reduce log hauling costs by improving a logging road. This is a cost savings type of project and the benefit from the project is the difference in hauling costs with and without the project, i.e., the cost savings. The output can be specified initially in terms of resources saved, i.e., reduced requirements for trucks, maintenance labor and spare parts, etc. These physical measures are then transformed at the valuation stage to monetary measures of costs saved. Similarly, a watershed protection project may be contemplated to reduce the cost of dredging of a reservoir that provides flood protection and regulates water flows for dry season use. The reductions in dredging equipment, labor, etc., required are identified as the physical measures of output or resources saved. (They are then valued in the next stage on the basis of what these released resources can produce elsewhere, i.e., the willingness to pay for the additional goods and services which these released resources can now produce in alternative uses.) In both cases, the relevant final comparison is between costs of alternatives, i.e., cost savings projects are considered in terms of the third condition for efficiency or by applying a least cost analysis.

It should be noted that cost savings projects can also be oriented toward preventing future cost increases. For example, the relative price for labor may be increasing and a project could be proposed gradually to reduce the labor input into a particular activity so that total unit costs can be maintained at present levels or at least prevented from increasing at a rate that would occur if the project were not undertaken. This type of project is closely related to projects designed to prevent losses.

In the case of projects that are aimed at preventing losses, the relevant comparison is between the value of the losses avoided and the costs of avoiding the losses through the project measures. Thus, at the identification stage, outputs are identified in terms of physical losses avoided. The approach is illustrated in a FAO document for a watershed protection project which involves land use improvements to reduce siltation in a reservoir.

Reduced siltation results in reducing the loss of storage capacity, which in turn results in reducing the downstream losses which are caused by the decreasing water availability from the reservoir. The losses avoided, or benefits in this case, are identified in terms of such downstream uses (since these are what society values, not the capacity of the reservoir itself).

Similarly, forest protection projects are aimed at reducing the risk of loss due to fire, insects, disease, etc. In these cases the probability of loss without the project and the reduced probability of loss with the project have to be estimated. The difference is the output or benefit due to the project. This task is appropriately done by the technical experts. Once such information is available, the task of the economist is to take the appropriate estimates of physical losses avoided and attempt to value them in a time context. Since the estimates of physical losses avoided will be subject to probabilities, so will be the values of these losses avoided. At the input and output identification stage, there are no particularly unique problems involved, although analyses involving probabilities are always more complicated to carry out (and require more data) than those involving the assumption of certainty.

Finally, there is the situation mentioned earlier where a project involves both losses avoided and production (output) increases over present levels. For example, assume a situation where an area of hill land is deteriorating due to erosion taking away the productive top soil. It has been, estimated that the production from the land will decrease over a 20-year period from level A to zero (point B) in figure 4.2. Now a project is proposed to build up production to level C in ten years and then maintain it at that level during the life of the project (year 25). The appropriate measure of output is area ACDE, plus the loss avoided, or area AEB. If only the production increase over present level were included, it would understate the output or benefits of the project.

Figure 4.2. Soil protection benefits.

If production is expected to continue at level C beyond the 25 year life of the project, then the benefits or output of the land beyond that period should also be included in the project calculations net of any additional costs required to maintain production at that level. In other words, at the end of the project period, there is a residual value (such as explained in chapter 3) that can be attributed to the project. It can be seen that application of the with and without concept is critical to proper benefit identification in these cases.

Table 4.2 provides an example of a physical flow table for a forestry project, showing how direct inputs and outputs are organized and how inputs are listed in the year(s) in which they are used and outputs by the year(s) in which they occur.

4.5 Identifying Indirect Effects

An indirect effect was defined earlier as any change in the quantity or quality of goods and services available to society due to the project, but one that does not enter into the accounts for the financial analysis, since it is not directly bought or sold in a market by the financial entity for which the financial analysis was done.

Table 4.2. Timing and magnitudes of physical inputs and outputs for assumed “average” 10 ha farm. ^a

^a From Case Study no. 1. See FAO 1979.
^b man days
^c Assumed that 25 percent would have to be replanted on the average.

A first point to note about indirect effects is that many of them cannot be meaningfully valued in monetary terms. However, they should still be identified in quantitative physical terms, if possible, and otherwise at least specified in descriptive terms. Regardless of whether or not they have an identifiable monetary value, they may be important in the broader context of decisionmaking, where many considerations other than monetary values are important.

A second point is that whenever an indirect positive effect is identified, the analyst should be careful to search for any corresponding indirect negative effect (cost) required to bring about the positive one. It is only the net indirect effect that can be attributed to the project.

The following discussion will illustrate this point.

4.5.1 Indirect positive effects

The following are the main indirect positive effects of concern in forestry projects:

• soil and watershed protection and wildlife and recreation habitat improvements that are not accounted for in the financial analysis;

• benefits accruing to society due to the fact that the project has trained persons to be more productive or has demonstrated the viability of some activity which is then undertaken by entities outside the project boundaries; and

• cost savings which result in output expansion and increased use of excess capacity outside the project, but due to the project activities.

Descriptions of each type follow.

Soil and watershed protection and natural forest conservation. Many projects involving establishment and/or management of forests also produce certain indirect effects in the form of improvements in soil or watershed protection services from the land (forest) and, possibly, improvements in wildlife habitats and recreation opportunities. In rare instances, these services are paid for directly to the project and thus enter the financial analysis as direct outputs. However, in most cases they are not directly priced in a market.

Quantification of such indirect effects depends on the availability of input/output information which describes the changes in output that will take place with a given forestry activity. In the absence of such information, there is little that the economic analyst can do to quantify them.

There are some studies which have been carried out for specific regions which link various forestry activities to watershed protection changes and further link these changes to consumption changes downstream.^[12] The transferability of such specific results to a broad range of project situations may be possible. The best that can be done is to rely on the judgments and figures provided by the technical experts. If such effects have been identified in quantitative terms, they enter the analysis in exactly the same way as any other quantified input or output.

Training and demonstration effects. A project may involve training of labor to increase its productivity. The training expenses are likely to be direct inputs into the project; however, the indirect effects due to the training are not accounted for in the financial analysis, since the project financial entity does not collect the increased revenues made possible by use of this better trained labor in other projects when the project is terminated or the labor leaves the project for other employment. It is very difficult to quantify this benefit and particularly to value it. Thus, it is generally included in the analysis in a descriptive fashion, for example, “100 laborers will be trained to operate power saws and this will increase their productivity in future years.” The training expenditure also results in benefits in the form of increased output per unit of input in the project itself. These should be accounted for in the direct output measures for the project.

Similarly, in many forestry project situations, extension efficiency and demonstration effects are important issues (see box 4.6). For example, a public project may involve support for establishing fuelwood plantations in selected communities. Once surrounding communities see the benefits to be derived from such plantations, they may on their own undertake to establish such plantations to meet their increasing requirements for fuel and/or to reduce the increases they are experiencing in fuel costs. The net benefits resulting from this type of demonstration effect can appropriately be attributed to the project being analyzed (even though the additional plantations resulting due to the demonstration effect are totally outside the project scope). The with and without concept can be applied to see which net benefits would not have been expected to result without the project. They can legitimately be attributed to the project. It should be emphasized though that it is only the net benefits that can be attributed to the project. If the additional outputs are to be attributed to the project, then care should be taken to attribute as inputs the resources and goods and services needed to bring about the additional output.

Cost savings and increased use of excess capacity in other sectors. If a forestry project results in production of lower cost wood than previously (i.e., more efficient wood production) there may be an increase in the use of wood in existing idle processing capacity outside the project boundaries. (The increases will be due to the fact that the price of the final product can be lowered since costs are lowered; demand for such products will increase because of the lower price, and therefore processing can increase to meet this demand.) The indirect benefits in this case will be the increased output resulting outside the project less the cost (the inputs) required to bring about this new production.

Similarly, a road project designed to reduce the cost of delivered wood (i.e., increase efficiency in wood delivery) may have indirect effects beyond the project. Such improved roads may be used by farmers who can lower their effective costs of delivery, thereby lowering farm product prices, which can result in increased demand and expansion of production (i.e., goods available for society to consume). Such increases can be attributed to the project in question (the road project) net of any increases in costs (use of resources) required to bring about these production increases. The appropriateness of attributing these net benefits can again be ascertained by applying the with and without concept.

This type of indirect positive effect should be distinguished from what is generally called a multiplier effect, i.e., a short-run increase in income generated outside the project when surplus capacity in an economy is activated by additional rounds of spending resulting from investment in the project. Forest recreation projects are often justified in terms of the additional expenditures which will occur in the communities adjacent to the recreation project. From a national point of view, such benefits need to be questioned. In most cases they are merely transfer payments in the sense that the expenditures would occur elsewhere in the absence of the project. Again, application of the with and without concept is critical in identifying true net indirect positive effects associated with such additional expenditures. They generally can be justified only in cases where the funds available for the project could only be used for the project being analyzed and not for any other project in the economy. This would be the case for tied grants and loans which could not be used for anything other than the project in question. In this case, it still only is the net effect which should be included, i.e., there may be additional nontied expenditures - outside the project boundaries - which are required to achieve the benefits or indirect positive effects in question.

Source: K. Christophersen.

4.5.2 Indirect negative effects

There are also certain indirect negative effects which may be associated with forestry projects. The main categories are

• pollution or negative environmental effects not accounted for by direct costs to the financial entities involved;

• increases in costs outside the project boundaries which influence production (cause decreases) elsewhere in the economy; and

• infrastructure costs not included as direct costs, but required for the project.

  Pollution and negative environmental effects. The common example given is a pulp mill that pollutes water that is put back into rivers, thereby reducing the quality of water downstream and consumption benefits of downstream water users. Similarly, such a project may reduce air quality. Often a measure can be derived of the amount of pollutants which the mill discharges into a river or lake. In some instances such increased pollution levels can be associated with losses in consumption benefits (e.g., loss of fish catch, increased health problems, etc.). Quite often, however, this type of indirect negative effect is merely described in the project document without making any attempt to value it since the necessary data on input-output relationships are not available. Increasingly, pollution is being internalized in projects through the use of effluent charges or requirements for pollution control equipment or project water purification expenses. In these cases, such effects enter the project analysis as direct effects or inputs, since they involve financial costs and enter the financial analysis.

  A similar situation exists with most other types of indirect negative effects involving deterioration of the environment, for example, soil deterioration and watershed benefits foregone due to a project that involves manipulation of vegetation upstream. Considerable research and study has been devoted to watershed problems and potentials for improving watersheds through forestry activities. There are some estimates of quantitative relationships available which may be usefully transferred from one situation to another. The judgment on transferability should be made by the technical personnel familiar with watershed management and the project.

  Cost increases affecting production of nonproject output. In some instances, a forestry project may result in the prices for certain inputs being increased. Such increases will affect other producers who have to curtail production. Reduction of their production releases resources, some of which may not be usable in producing other goods and services. If there is a net loss in the value of goods and services available to society due to such a project effect on prices, then this is legitimately attributed to the project as an indirect negative effect. Such a net loss would result if some of the resources released had no alternative uses and thus remained idle when the project-caused cost increases put them out of work. For example, if the project demand for imported machinery results in the price for such machinery increasing to the point where certain other activities cannot afford it and they have to shut down, then they release labor and other resources that may not be able to find alternative employment. The reduced output value from the activities that shut down, less the new value produced by those released resources which find alternative uses, would be a measure of the indirect cost of the project being analyzed.

  Infrastructure costs. As mentioned earlier, it is common that some of the infrastructure - roads, community facilities, power generation and communication facilities - which have to be produced for the project are not paid for directly by the financial entity for which the financial analysis is being undertaken. In such cases, the costs associated with such infrastructure have to be included in the economic analysis as indirect negative effects of the project, to the extent that their provision involves use of resources that could have been used in the absence of the project to produce other goods and services valued by society. Both capital and operating costs associated with such infrastructure have to be considered. At the same time if certain infrastructure items will be used outside the project boundaries, then allowance should be made for such use as an indirect positive effect. Again, the with and without test is applied to infrastructure.

If infrastructure is produced and operated directly by the project entity or entities for which the financial analysis is undertaken, then it should have been included in the financial analysis, even if it is entirely subsidized by the government or some other entity not considered in the financial analysis. The exception is if the financial analysis netted the project expenditure against the subsidy. In this case the cost to the financial project entity would not appear in the financial accounts. In such cases, the cost should still be included in the economic analysis. The cost of the infrastructure is real. It is impossible to generalize on how such subsidies and infrastructure expenditures are handled in the financial analysis. In each case the analyst preparing the economic analysis has to look at the project's financial accounts and make sure that costs to society are included and subsidies are appropriately treated as transfer payments as suggested in chapter 6.

Common categories of infrastructure which the analyst should examine critically include those shown in table 4.3.

4.5.3 Additional points: Indirect effects

What is to be done in terms of identification of indirect effects? There is no one best way to proceed, since there are few ready and available sources of information on most of such effects. Success in identifying indirect effects depends a great deal on experience and knowledge of relevant interrelationships based on study of other projects and technical literature. Interaction between various technical experts is essential, since identification of most indirect effects depends on information related to technical relationships.

Table 4.3. Infrastructure categories checklist for economic analysis.

Source: R. G. Steele (1979).

Given some general ideas on potential indirect effects of given types of activities the analyst can proceed to estimate whether any given type will be relevant for the particular project s/he is analyzing. If the analyst decides that it is likely to be relevant, then s/he can discuss with technical experts the likely physical magnitudes of the effects (both positive and negative) and list these in a separate table (or tables). Where it does not appear possible to estimate magnitudes (quantities involved) the analyst should still develop a statement describing the nature of the effect expected in as specific terms as possible.

Some indirect effects will be accounted for in the economic analysis through shadow pricing of direct inputs and outputs and will, therefore, not appear as separate costs or benefit items (see chapter 5). For example, if water used in a pulp mill is shadow priced to reflect its true opportunity cost, then this shadow price (cost) should incorporate the value of opportunities for using clean water downstream that are foregone due to the project polluting downstream water. Since identification and valuation are closely interrelated, in practice the two steps are often carried out simultaneously, i.e., a given effect is identified and then valued at the same time. The distinction between identification and valuation here is made for clarity of exposition and to emphasize the point that even though a given effect cannot be valued in monetary terms, it should still be identified and specified as explicitly as possible.

4.6 Location Related Inputs and Outputs (Effects)

As mentioned earlier, inputs and outputs or effects associated with a project should be identified in such a way that the process of valuation is facilitated. Since many inputs and outputs will be valued directly or indirectly on the basis of (market) prices that are established in locations other than those where projects produce outputs or use inputs, it is important to pay special attention to the handling, marketing and transport functions and to properly identify the inputs used in these functions due to the project or saved by producing an output in the project rather than importing it or producing it somewhere else in the domestic economy. This category of effects relates closely to infrastructure inputs discussed previously.

As in the case of infrastructure (and other inputs and outputs), location related effects can be identified as direct inputs and outputs or as indirect effects depending on the nature of the project and the financial analysis being carried out. The important point is that they be included in the analysis and not that they are classified correctly as direct or indirect.

Location related effects which need to be considered can be divided into general ones, i.e., relevant for all types of projects and specific ones, i.e., specific to certain types of projects which involve substitutions (as explained below). In both cases, they only arise when

• the value measure (price) which is to be used for a direct project input is established in a market, or at a point which is different from the point of use of the input in the project, and

• the value measure (price) to be used in valuing a project output is established in a market or location that is different from the point of use of the output and/or different from the point of production of the output.

Thus, this type of effect is one that can only be identified properly in the context of the valuation system which will be used. This emphasizes the point made earlier that in practice identification and valuation often have to be carried out simultaneously for some types of project effects.

4.6.1 General effects

1. For all direct project outputs the analyst needs to identify inputs required to handle project outputs and move them to their intended point(s) of consumption (or export) at which their values are determined. For example, in the case of an export output, it will be valued on the basis of its export price, generally determined at the port of export. (This will be discussed in the following chapters.) In this case, the inputs - handling and transport - associated with getting the output from the project point of production to the port in which the export price is determined should be included as inputs in the project accounts (the physical flow table and, later, the value flow table).

2. In the case of all direct inputs used in a project, the additional inputs required to handle and to move such direct project inputs (resources, goods or services) from their point(s) of origin (or the location(s) at which their prices are determined) to the point(s) of use in the project need to be included in the project accounts. For example, in the case of imported inputs, which will be valued on the basis of an import price established at the port of import, the handling and transport inputs from that port to the point(s) of use in the project need to be included.

4.6.2 Specific effects

In addition to these two general considerations (which should be considered for all inputs and outputs) there are two special cases where a project can result in positive effects (cost or resource savings) which must be considered and identified where relevant.

Import substitution

In the case of a project output which substitutes for an import or a domestically produced output, the project will often result in a savings of handling and transport inputs which would have been incurred in the absence of the project. These inputs are saved because the good or service being substituted by the project output will not have to be handled and transported from its point of origin (e.g., port of import) to the market(s) or point(s) of consumption in which its local market price (or w.t.p. for it) is determined. For example, in the case of import substitutes which will be consumed in market A, it will no longer be necessary to handle and transport the import from the port of import to market A. The resources saved due to the substitution are a positive effect of the project, if they have productive uses elsewhere in the economy. This will be determined in the valuation stages. At the identification stage such resources saved due to the project should always be included. (Of course, the effects described under [1] in section 4.6.1 would also be included [see box 4.7 for an example].)

Project inputs which would have been exported

In the case of a project which uses as an input a local resource or locally produced good or service which would have been exported in the absence of the project, use of the input in the project will result in savings in additional resources which would have been required to handle and move the particular project input in question from its point of origin to the port of export to point(s) of use in which its price is determined. These savings of additional inputs are legitimately identified as positive indirect effects due to the project in the stage being discussed here (see box 4.8 for an example).

In both cases above, the need to include the effects mentioned arises from the nature of the measures of value which are commonly used and the fact that such measures are determined in locations which are different from either the project location or the point(s) of consumption (or export in the case of the second type of effect). In all cases, whether or not the identified additional inputs or indirect positive effects will be assigned a positive or zero value depends on whether or not the additional inputs used or saved have any alternative productive uses (i.e., opportunity costs). This is determined in the valuation stage.

In the following chapter, which deals with valuing inputs and outputs, it will be assumed that location related project effects have been explicitly recognized and identified in this earlier stage in the analysis and thus will be valued independently of values assigned to direct project inputs and outputs. This approach has the advantage of clearly pointing out handling and transport inputs and not confusing decisionmakers by netting out transport and handling costs from established prices used to value direct project outputs or inputs.