Part I.
The Economic Assessment Process

The purpose of part I is to explain the economic assessment process. Specific analysis techniques and principles are explained in part II under chapters which correspond to the main economic analysis activities - identifying inputs and outputs, valuing inputs and outputs, comparing costs and benefits, and dealing with uncertainty.

Figure I.1 indicates the three main steps in the economic assessment process, whether one is working at the project identification, planning, implementation, or termination stages of a project. These steps are explained in part I - presenting and using the results in the most effective way possible.

Figure I.1. Part I. The economic assessment process.

^a/This amounts in most cases to selecting a set of techniques and the information which will be used.

1.
Determining the Questions to be Answered

The first step in an impact assessment is to determine what questions it should answer, i.e., what are the key questions that those who are impacted by the project and those who make decisions about the project want answered? Broadly speaking, in the case of forestry projects, these groups include some or all of the following: government agencies, NGOs, corporations, rural inhabitants and farmers, forest owners and users of various types. All the groups that make decisions about, and are impacted by, a given project are referred to here as the interested parties.

In many cases, specifying the relevant questions in an operational form requires an interactive and iterative process involving the analyst and those making decisions about the project. There are two reasons why this type of interactive process is useful. First, decisionmakers may not have specified clearly enough the questions they are asking, thus creating confusion for the analyst. Second, certain relevant financial or economic efficiency questions may not occur to decisionmakers, even though they are quite relevant in the context of the project under consideration. By developing a clear specification of the questions to be answered, the analyst is essentially defining and refining the overall purpose of the assessment. Time and effort will be saved if this is done, and done well, prior to initiating the economic assessment.

1.1 Considering a Range of Questions

There are five basic financial and economic efficiency questions that are, or should be, of concern to the interested parties dealing with forestry projects of various kinds. These are as follows:

1.1.1 Financial questions (those related to actual expenditures and receipts)

1. Is the project financially acceptable to the interested parties? Do the interested parties (particularly private ones) have sufficient financial incentive to participate? What will be the cost and benefit flows to private investors or to participating farmers and landowners? If they do not find the project attractive enough, then it may be necessary to consider providing subsidies or other types of incentives. That is a main reason why this question is addressed.

2. How are the returns and costs of the project distributed among the different interested parties? This boils down to the question of who pays and who gains? It relates to the previous question and it is a question that also is of central concern in social impact assessments, where nonmonetary as well as monetary benefits and costs are included. Countries often are concerned with income redistribution effects of public investments, i.e., the equity issue. In most projects, concern centers on different income classes (do poorer members of society receive more benefits than richer members?), regional groups (does region X receive more benefits than region Y?), or cultural groups (does clan A benefit more than clan B?) or on gender (do men benefit more than women?). Intergenerational equity issues might also be of concern (how will future generations be affected; will the next generation reap benefits or costs from the project?).

3. What are the budget and financial sustainability implications of the project? Does the project stay within budget limitations? What funds will be needed to cover operating expenses? When will funds be required to support the project (outflows) and when can receipts (inflows) be expected? What are the recurrent cost requirements in the future, e.g., for road maintenance, forest management costs? The whole question of cash flow and ability to maintain it is relevant here. Other issues of interest here are regional income and job stability. For example, a recreation project of a highly seasonal nature may involve a great deal of instability in terms of income flows: or a timber harvesting project that does not adequately take into account sustainable timber production over time may have an initial positive impact on incomes and economic activity, but eventually result in hardship and instability as the level of economic activity developed initially can no longer be supported by available timber. (This also relates to the distributional question above.)

4. How does the project affect foreign exchange balances for the country or region? This question relates generally to the foreign exchange impacts. In countries with large net outflows, this question is of critical importance, and may influence decisions on foreign exchange expenditures in projects and on subsidies and tariffs.

1.1.2 Economic efficiency questions (going beyond monetary costs and returns)

5. Does the project involve an economically efficient use of resources? In other words, do the benefits to the nation, or to the relevant subunit of the nation, exceed the costs of the project, when both are appropriately valued and discounted to a common point in time? If there is some way of making better use of the nations resources, then the answer is “no.” We also have to ask: could we eliminate any of the separable components of the project and get higher net benefits; or could we obtain the same benefits with lower cost or with less use of resources? When a main project objective is to increase the aggregate economic benefits (goods and services) derived from the use of the country's limited resources, then the economic efficiency question becomes the central one of concern to public decisionmakers.

1.1.3 Differences between the financial and economic efficiency analyses

In this paper, we use the term economic assessment to encompass both financial and economic efficiency aspects of impact. There are two fundamental differences between financial analysis, used to answer the financial questions above, and economic efficiency analysis, used to answer the economic efficiency questions. The differences relate to (1) what costs and benefits (or positive and negative impacts) are included in the assessment; and (2) how those costs and benefits (impacts) are valued (see table 1.1 which summarizes the differences by the steps in the analysis process).

The term financial analysis is used to describe the type of analysis that is concerned only with actual monetary flows from (cost) and to (return) specific individuals or groups of individuals within society - farmers, private firms, public corporations, and others. In this sense, financial analysis deals only with those goods and services for which people pay or are paid. It deals with the actual monetary payments involved, e.g., for labor, capital, land. Financial analyses always have to be done from a specific interested party's point of view - government agency, private firm or individual, cooperative, etc.

Table 1.1. Relationship between steps in a financial and an economic efficiency analysis.

Economic efficiency analysis, on the other hand, is concerned with the costs and benefits to society as a whole, regardless of who pays and who gains. It deals with benefits measured in terms of what society actually is willing to pay for goods and services, and costs in terms of the opportunity costs involved, e.g., the values of the opportunities foregone when a resource is used for one purpose rather than its next best use that actually would have occurred. This concept is valid regardless of whether or not money actually is paid for a good or service.

The economic efficiency analysis, like the financial analysis, is concerned with profitability, but it is profitability from society's point of view, which is related to the return society as a whole can obtain with a given use of its limited resources. In most cases, the nation is taken as the unit of society. But it could just as well be a state or smaller unit (part of a nation).

In economic analysis, market prices often are adjusted to more accurately reflect social or economic values. These prices are referred to as accounting or shadow prices. For example, if there is significant structural unemployment, and a project employs otherwise unemployed laborers, then in the economic efficiency analysis we might apply a labor value lower than the ongoing wage to reflect a lower opportunity cost for such labor that otherwise would be unemployed.

If both financial and economic efficiency questions are being asked, they generally are carried out together since both have much in common in terms of information requirements and procedure. The steps in a financial analysis are more straightforward to carry out and clearer in concept. Therefore, assessments generally start by answering the financial questions related to financial profitability and then the results of this step are used as a starting point for the parallel step in the economic efficiency analysis.

1.2 Need for Question Specificity

Decisionmakers may ask a question without specifying it in enough detail to answer it. In that case, the analyst will have to elicit specification. For example, if the decisionmaker merely asks, what is the financial worth of the project? the analyst will have to ask: financial worth from whose point of view, and what is the measure of financial worth the decisionmaker wants? Similarly, an economic efficiency analysis can be carried out from the national, the regional, or the local point of view. The point of view needs to be specified, since the information required and the results generated will be different for different points of view.

In the case of income distribution questions, there is a need to be quite specific about which groups are of interest. For example, what do we mean when the question is asked: What are the benefits to low income project interested parties? How shall we define low income in the assessment? Some interaction with the decisionmaker is necessary in order to reach agreement on these types of points. In sum, questions have to be specific.

Sometimes decisionmakers will not think of all the relevant financial and economic efficiency questions which need to be answered in order to move ahead constructively with a given project. For example, the decisionmaker may overlook the need to conduct a financial impact analysis from the point of view of potential private participants. Such information is needed in order to make decisions concerning subsidies and charges or fees, and in order to obtain a better understanding of the factors which most likely will influence private participation in the project. If the decisionmaker omits such questions, then it is the analyst's responsibility to make sure that they are considered.

In some cases the analyst may take the initiative in discussing questions early on with the interested parties. The assessment results are more likely to satisfy the interested parties if they have interacted during the early stages in defining the purpose of the assessment.

When proposing that an economic impact assessment be conducted, decisionmakers sometimes neglect to consider the perspectives or questions of all the interested parties involved. The interested parties control resources and must decide whether to commit these resources to a given project and how much to commit. The assessor has to keep this in mind when defining the full array of questions to be dealt with. For example, a project can be extremely attractive from a national economic efficiency point of view, but if it is not also financially attractive to all private entities which have to commit resources to it, then it will not be undertaken as planned. A financially unattractive project can be made financially attractive if the government (the public) provides subsidies (incentives). Whether or not such subsidies are considered justifiable in a social economic context depends directly on their required magnitude in relation to the economic surplus associated with the project (economic benefits minus economic costs, appropriately adjusted to take time into account). Similarly, analyses which show that a project appears to be more attractive financially than economically may provide some indication of the desirability to tax the interested parties involved.

Questions also need to be adjusted to the stage in the project development process. Some of the differences are indicated in table 1.2.

Table 1.2. Questions of relevance at different stages in the project process. ^a

^a These should include the main questions of interest to all those groups involved in the project.

2.
Designing the Assessment Approach

One could go about answering the various questions of interest put forth in chapter 1 in a number of different ways. Before deciding on the specific method to use it is important to design the overall approach that will be used in the economic assessment (which likely will include answering a number of questions). This includes considering

• the common principles and processes for addressing different questions, and

• the constraints on the overall assessment.

The first consideration can help make the overall assessment more effective and efficient by avoiding unnecessary duplication of efforts as each question is addressed. The second consideration is important so that resources can be allocated properly to each of the questions which needs to be answered and so that timing of efforts can be adjusted to reflect needs and resource constraints.

Even though the questions discussed in the previous section are quite different in terms of answers and empirical methods for answering them, each one of them should be addressed or analyzed using a common economic analysis process or set of steps, keeping in mind certain basic principles which apply regardless of which question is being answered.

2.1 Using the With and Without Principle

A project impact can be defined as the difference with and without the project. This with and without concept is basic to project analysis. It is important to keep in mind that the situation as it exists today would likely not remain the same in the absence of the project. Thus, the before project situation should not be taken to be the same as the without project situation when identifying project effects. Changes would likely take place without the project and these need to be estimated (see box 2.1).

When substantial change is not expected without the project during the period of the project, the analyst may be justified in saving time and money by assuming the before project situation would have held constant over time. However, there are many forestry projects - which generally involve long time periods - where ignoring potential changes over time without the project will involve some major under- or overestimation of costs and benefits.

In applying the with and without concept to economic costs (or opportunity costs), particular care has to be taken to identify properly the best actual opportunity foregone, i.e., the best alternative use of an input that actually would have taken place without the project, taking into account the various institutional (social and political) constraints or policies that are expected to exist (see box 2.2). One of the classic guides to economic assessment, the UNIDO Guidelines, makes this point as follows:

“The technical opportunities that cannot be made use of, given social constraints, are not real opportunities, and the identification of costs as maximum benefits sacrificed must be based on real feasibility.... The starting point of all project evaluation is to ask the question: If we did not choose the project, what difference would it make? And the assessment of the differences that would result depends on a clear identification of political and social constraints that limit economic opportunities” (UNIDO 1972).

2.2 Considering Interdependence and Separability of Project Components

Most projects consist of interrelated components. In terms of costs and benefits, these components will either be interdependent or separable. Some components of a project can be defined separately in the sense that most of their costs and benefits are independent from the rest of the project and the components can be added to (eliminated from) the project without affecting its overall feasibility, although they may obviously affect its overall profitability or economic efficiency.

For example, consider a watershed management project that has agroforestry, soil conservation, agriculture and farmer organization components. If the inputs and outputs of one or more of these components can reasonably be separated from the inputs and outputs of the other components, then they should be analyzed separately in terms of impacts.

For any project and purpose the question is: Does it make sense to separate components in the context of the purpose for the analysis, i.e., in terms of the questions being asked?

The answer depends very much on the viewpoint of the institution for which the analysis is being carried out and on the questions being asked. However, in general if major separable components and their costs and benefits can be identified, then they should be analyzed separately, since each separable project component should have benefits at least equal to costs in order for the total project to be considered an economically efficient use of resources.

The answer also depends to some extent on the stage in the project planning process. At the early stages, when alternative combinations of components and project sizes are being explored, it makes sense to separate out components and to analyze them individually and in combinations. This is indeed one of the main functions of the project identification and preparation stages in the planning process, and one of the main uses for economic analysis at these stages. However, once a project alternative has been shaped and designed in detail, it may make little sense to spend much time on detailed analysis of components that already have been analyzed and accepted in the earlier stages of planning.

2.3 Considering Constraints on the Assessment

The assessment should not only be effective, that is, provide appropriate answers to the questions being asked, but also be realistic in its approach, in recognizing the practical constraints under which the assessment is being conducted. Consideration of these constraints will help the analyst plan and organize the assessment. Figure 2.1 indicates the considerations that should be taken into account.

1. Technical considerations. Technical considerations include: data requirements and data availability; cost; time requirements; and reliability, reproducibility, and acceptance in the scientific community. Different assessment questions require different kinds of data. For example, an assessment that includes an analysis of the distribution of costs and benefits would require considerably more detailed data and information than one that considers only aggregate impacts. Such a distributional analysis also is likely to require considerably more time to obtain and process the required input data, and to actually carry out the analysis, than would be required for an aggregate analysis. Some methods of analysis may be more reliable than others, and be more easily reproduced by other analysts. This may or may not lead to greater acceptance in the scientific community. For example, assessments based on observed and reported market values may be more easily reproduced by other analysts than assessments which involve unique estimates to account for nonmarket values, and thus be more readily accepted by the scientific community. Yet, some segments of the scientific community may give greater credence to attempts to account for nonmarket values that are known to exist, even though the methods of accounting for those values are not as widely accepted.

2. Decisionmaker/user considerations. The actual purposes and importance of the assessment in decisionmaking are primary considerations which should dictate how an assessment is designed and organized to give it maximum usefulness (make it timely and relevant for the intended use and purpose).

Time and skills are important constraints in designing assessments in most developing countries. It takes time and appropriate skills to plan an assessment, to collect, process, analyze, and synthesize data and information used in an assessment, and to write up the report on the analysis, have it reviewed, and disseminate it to potential users. The amount of time available in which to conduct an assessment must be carefully considered in deciding which questions can be answered, and in the choice of methods by which the questions are to be answered. If the time necessary to complete all of the tasks on the assessment is longer than the time framework initially set by the decisionmaker, some adjustments will have to be made. Perhaps the time frame can be lengthened, or more personnel obtained, or some of the questions modified, or assessment methods changed.. Again, this must be an interactive and iterative decision process between decisionmakers and analysts.

An important constraint in conducting any assessment is the amount of funding, skills and time available. In proposing an assessment, decisionmakers may have a preliminary total budget for the assessment in mind. But until the questions to be answered by the assessment are clearly specified in operational terms, the costs of the assessment cannot be estimated. Once the questions are specified, it is up to the analysts to determine what it would cost to answer these questions. If the cost of conducting the assessment is within the proposed budget, the decisionmaker may decide to go ahead with it. However, if the cost of the proposed assessment exceeds the proposed budget, a decision will have to be made as to whether the budget will be increased to cover the costs, or some of the questions to be answered will be eliminated or modified. Or, it may be possible to modify the assessment approach to use a less costly method to provide more general answers that are not as precise.

Figure 2.1. Constraints affecting the assessment approach chosen.

Fitting assessment to budget and vice versa is one of the needs which argues for an interactive process between decisionmakers and analysts.

Finally, there is the question of credibility of the assessment and the assessor to be considered. This depends on: the reputation of the assessor (something which is built up over time); the ease with which the assessment process and results can be understood; the way in which uncertainty is handled (the transparency of the assessment); the extent to which the assessor draws on results of parallel assessments and indicates similarities and differences; and the acceptability of the results by decisionmaker advisors and technical personnel, which depends to a great extent on all the other items mentioned above.

2.4 The Basic Assessment Steps

The process described below is a basic one that can be used in answering both financial and economic efficiency questions, regardless of the stage in the project development process, and regardless of the number of iterations at each stage. The differences in how the process is used at different stages in the project cycle relate to the purpose of the assessment, the assessment question to be answered, the sophistication of the estimating techniques used, the amounts of data required and collected, and the level of detail considered and time devoted to the analysis.

Step 1. Identifying and quantifying inputs and outputs

For any question being addressed, the first step in the analysis process is to identify physical inputs and outputs; what goods and services go into the project and what goods and services are produced by the project. This identification should be done for each of the separable components being considered in the assessment. Preparation of a table which clearly indicates the physical flows of inputs and outputs (see table 2.1) facilitates the assessment process. In answering the financial questions, only market priced inputs (those involving a financial outlay by the interested parties) and market priced outputs (those involving financial income or returns to the interested parties) are included. For example: market priced inputs may include project personnel person/days, vehicles, gallons of gas, equipment or, seedlings; market priced outputs may include poles, crop yields, or bales of fodder.

In answering the economic efficiency questions, nonmarket inputs and outputs should be considered in addition to the market priced inputs and outputs. Nonmarket inputs and outputs are those associated with (used in [produced by]) the project, but which the project does not buy or sell. These are external to the project in a financial sense since they involve no direct monetary inflows or outflows. For example: nonmarket inputs might be volunteered labor, subsidized water, or donated land. Nonmarket project outputs might include; free fuel wood, offsite erosion control, water pollution (negative output), or enhanced carbon storage.

Table 2.1. Physical flows of project inputs and outputs.

Step 2. Valuing inputs and outputs

The next step in answering both the financial and the economic efficiency questions is to develop unit value tables for the inputs and outputs with due consideration given to trends in prices and forecasts or projections of future prices. When market prices have been identified for the financial analysis, a large overlap will likely exist with the economic analysis, i.e., most of the input and output items included in the financial analysis will also be represented by similar ones in the economic accounts.

However, market prices may not adequately reflect social costs or benefits associated with the project, or the opportunities foregone by the project's uses of resources. There can thus be differences in the values attached to such common inputs and outputs and these have to be considered in deriving the economic unit value tables. Unit values used in the financial analysis are market prices. In the economic analysis, inputs and outputs are valued on the basis of consumers' true willingness to pay (w.t.p.) for them. Market prices may or may not adequately reflect w.t.p. If they do not do so, then shadow prices must be developed.^[1]

Derivation of unit values for the economic efficiency analysis involves a two stage process. First, for inputs and outputs traded in a market, a judgement is made on the adequacy of market prices used in the financial analysis as measures of economic value. If they are judged to be adequate, they are entered in a table showing unit economic values. If they are judged to be inadequate, then they are treated in the second stage just like indirect effects for which no market prices exist.

This second stage involves a judgement on whether or not an acceptable shadow price can be developed for all the inputs and outputs (market and nonmarket) considered in the economic efficiency analysis. If the judgement is negative, then it is better to treat the effect in a qualitative or physical quantitative fashion, by making explicit mention of the effect in the economic analysis report and referring to the financial value. The analyst should not try to develop a spurious value measure which will merely serve to confuse and mislead decisionmakers. If the judgement is that a shadow price can be developed, then the analyst proceeds to do so and the resulting values are entered in the unit value table.

Step 3. Conducting the analysis (answering the questions, given the value information derived in the previous step).

This third step involves comparing costs and benefits in various ways to answer the relevant financial and economic efficiency questions. Two common measures for looking at financial and economic efficiency are the net present worth (all discounted benefits minus all discounted costs) and the internal rate of return (the discount rate that makes all discounted benefits equal to all discounted costs or the net present value [NPV] equal to zero). These measures are used for both economic and financial analyses. The analyst also can choose to conduct a different analysis from the different interested parties' perspectives. For example, the value flow table might include costs and benefits that are accrued to participating farmers as well as to the overall project. The analyst could separate out those costs and benefits specific to each group, and conduct an analysis to determine how the project impacts the interested parties from their own perspective. The same could be done for foreign exchange and local currency expenditures.

Step 4. Dealing with uncertainty: Sensitivity analysis

Uncertainty is an inherent companion of projections and ex ante assessments. Accurately or precisely identifying, valuing, and comparing costs and benefits is always a problem. Future costs and benefits cannot be measured, but only estimated. Thus a degree of uncertainty surrounds every estimated value. Information is nearly always limited and of limited quality. For this reason, a major function of economic analysis is to test the sensitivity of selected measures of project worth to changes in assumptions concerning inputs and outputs and the values attached to them (a sensitivity analysis). Such information can be extremely useful for decisionmakers.

3.
Answering the Financial and Economic Efficiency Questions

After deciding upon the questions) to be answered by the assessment, and after developing the assessment approach to be followed, the analyst can start to answer the questions. The first step is to determine the actual method that will be used to answer each question. The purpose of this chapter is to assist the analyst in choosing a method to answer the assessment questions, Part II deals with techniques. The overall framework for answering the questions is illustrated in figure 3.1.

Figure 3.1. Basic process for answering financial and economic efficiency questions.

3.1 Methods for Answering Financial Questions

Each of the different financial questions discussed in chapter 1 can be asked at different stages in the project process. Differences in how each question is answered will relate to the estimating techniques used, the quality and amounts of data required, the level of detail considered, and time devoted to the analysis. When conducting an assessment, project information generally is presented in a set of interrelated working tables. Some basic project information will be required regardless of which financial question is being answered, and will be required also in the economic efficiency analysis. This information includes project physical flows of inputs and outputs and the market prices associated with those inputs and outputs. Additional information and tables will be required depending upon the question being answered.

An example will be used to illustrate the overall approach to answering the financial and economic efficiency questions.^[2] It involves a hypothetical project in which about 200 private farmers plant trees on a total of some 2000 ha of their own, marginal farm land. The government is sponsoring the project by providing technical assistance, cash subsidies for planting, and the planting stock. From the government's point of view, the total planting program is duly treated as a project.

3.1.1 Is the project financially acceptable to the interested parties?

Financial acceptability can be different things for different interested parties. Conventionally, financial attractiveness is determined when the following three criteria have been met:

1. the value of aggregate benefits is greater than the value of the aggregate costs when both are appropriately discounted with the alternative rate of return (ARR),^[3] i.e., the net present value (NPV) of the project is greater than zero;^[4]

2. the discounted value of benefits is at least equal to the value of costs for each separable project component; and

3. there is no lower cost means available for achieving project objectives.

The same analytical method is used to answer the question about financial acceptability regardless of when in the project process the assessment is conducted. Generally, only the type and quality of the information used in the analysis, and the number and types of interested parties might differ from one project stage to another. For example: if asking this question during the project identification stage of a proposed farm forestry project, the analyst must use crop and tree yield and price estimates from whatever sources seem to fairly represent the proposed project area, and must make rough estimates of the number of participating farmers and the rate at which they will adopt the proposed techniques. If asking this question during the evaluation stage, then the analyst will use actual yield, price and adoption rate data from the project.

The first step is to identify the interested parties, or the entities which will or do have a financial stake in the project. The nature of the interested parties is highly dependent upon the type of project, they might include farmers, community organizations, financial institutions and various enterprises. Following the analysis process outlined in chapter 2, in the second step, the analyst identifies project components which impact the various interested parties, and the physical inputs and outputs related to those components. The third step is to estimate or obtain market prices for the inputs and outputs. In the fourth step, market prices are used to estimate cash flows for each interested party group; and various measures (NPV, financial rate of return [FRR], etc.) are calculated to indicate financial incentive for the interested parties' participation (see chapter 6 and annexes). The interested parties' ARR would be compared with the FRR for the project alternative. A major assumption is that if the NPVs or FRRs are high enough, then private investors will participate, ensuring feasibility for the project component particular to the interested parties. Public uses for information on private interested parties' FRRs are indicated in box 3.1.

In the example used in this chapter, the question of financial attractiveness can be determined by first identifying physical inputs and outputs to the interested parties - aggregated for private landowners and for the forest agency (tables 3.1 and 3.2). The contents of these two tables are summed to generate a single table displaying aggregate project inputs and outputs (table 3.3). A table of market prices and forest agency expenses permit the calculation of cash flow tables for the total project, or for each of the interested party groups. Table 3.6, based on tables 3.2 and 3.4, represents estimated cash flows to the participating farmers. This table, together with an estimate of relevant alternative rates of return for the private participants involved, provides the necessary information for answering the financial attractiveness question for the farmers in aggregate. The assessor may also look at variability within the group.

Table 3.1. Forest agency - inputs and outputs.

^a m.-d. - man days
^b Item in this column are per year during period shown.
^c Seedlings are given to landowners by the Agency.

Table 3.2. Private landowners - inputs and outputs.

^a m.-d. = nun days.
^b Items in this column are per year during the period shown.

Table 3.3. Project physical inputs and outputs.

^a m.-d. = man days.
^b Items in this column are per year during period shown.
^c It is assumed that the same land is used every year.

Table 3.4. Estimated market prices. ^a

^a In real terms, i.e., in fixed dollars per unit (e.g., 1990 dollars) of different times are involved.
^b Including operating cost. Price of equipment based on import value.
^c Entered as rental cost.
^d Based on FOB price, adjusted to take into account transport and handling costs from forest.

Table 3.5. Forest agency outlays. ^a ($l,000/year)

Source: Tablet 3.1 and 3.4.

^a This table could also include increased tax returns to government due to the project. In that case, it would detail total government outlays/inflows, and not merely forest agency consideration.

Table 3.6. Cash flow table for private landowners ($l,000/year).

Source: Tables 3.2 and 3.4.
^a Space for entry of subsidy figures, if one wants to study the consequences.

3.1.2 What are the income distribution impacts?

Again, the approach to answering this question will be much the same regardless of the stage in the project process at which the analyst is conducting the assessment. Information characteristics and the nature of the groups of interest may vary. Income distribution is a topic of interest in both economic and social impact assessments, and thus coordination between economists and social scientists in formulating the parameters of the response to this question is beneficial. Most often the question relates to how costs and benefits associated with a given project alternative affect different income groups, i.e., do poorer persons gain more than richer persons. Distribution of costs and benefits across regions or even generations might be of interest. The types of tables calculated for answering the previous question can also be used.

There is no single acceptable measure of the effect of the project on income redistribution. In other words, it is not possible to put forward one measure for income distribution impacts that can be used to judge whether the project is acceptable or unacceptable in terms of this question. Rather, the decisionmaker must be presented with estimates of positive and negative impacts on different income groups over the life of the project.

In the example, table 3.8, derived from tables 3.4 and 3.7, provides the necessary information to answer the question regarding employment impacts by income groups. The project generated additional employment in the area, and this employment impacts different income groups to varying degrees. In some cases, the table itself is all that is needed. In other cases, the information could be presented in comparative form, in a table or graph showing relative impacts of different project design. The NPV of each schedule of additional income could also be calculated for each group.

Table 3.7. Additional direct employment by income groups (man days/year ^a).

^a Similar tables could be prepared showing indirect employment effects.

Table 3.8. Additional income by income groups ($l,000/year).

Source: Table. 3.7 and 3.4.
Note: Supplementary tables could be used to show the average rate changes due to project.

3.1.3 What are the budget and financial sustainability implications?

Simple accounting of the flows of public funds and the receipts by the government provide the best information that can be used to answer this question. A financial rate of return (FRR) for the public sector (or the responsible agencies) could be calculated - but, in most cases, financial rates of return provide little guidance concerning desirability of public projects. There is no single measure that can be calculated to answer this question. If an agency has budget guidelines set at the project level, then the information provided by a table showing the required financial contributions for the agency over time can be used to see if the project can be realized within existing budgets (see table 3.5).

Decisionmakers have to decide whether or not the proposed budget for the project is acceptable and how the project compares with other possible uses of agency funds. If the proposed project budget is too large, then the project can be redesigned on a smaller scale, or if that is not possible, it can be rejected as being not feasible under existing budget constraints.

When considering either providing or accepting funds for new projects, decisionmakers must also consider the critically important issue of recurrent costs of the project and the ability of the implementing agency to support those costs once outside project funding is halted. The benefits of many projects have failed to continue beyond project termination because the local capacity to pay those costs was not considered during planning, or developed during the project period.

Other stability impacts may also be of interest such as, effects on the pattern of jobs and employment over time, or the minimum rate and periodicity of income to different groups. This is an assessment topic where economic and social analyses overlap. It is an area in which there should be coordination of the project appraisal process to avoid duplication, but also to insure that relevant impacts are covered.

3.1.4 How will the project affect foreign exchange inflows and outflows?

If the analyst is answering this question in terms of whether or not the project uses more foreign exchange than it brings into the country or saves for the country through import substitution, s/he must identify all project inputs or outputs which are either imported, substitute for traditional imports, or are exported. The value of these commodities must also be determined at the FOB or CIF prices and in their respective currencies. The black market exchange rates should also be taken into account. The main problem in answering the question is whether or not secondary foreign exchange effects should be included, i.e., the foreign exchange effects which are caused by the project, but not directly accounted for by imports of project inputs; by exports of project outputs; or by substitution of output for imports. For example, a given project may have a positive effect on foreign exchange earnings in direct terms, but may result in large increases in imports in other sectors.

Assume a plantation project that will produce wood for an intended expansion of domestic pulp and paper production and some wood for export. There are no imported inputs and some foreign exchange earnings through wood exports. Looked at in isolation, the plantation project has a positive impact on foreign exchange earnings. But assume that the pulp mill expansion involves large imports of foreign equipment and expertise. In this case, the secondary effects of the overall activity (plantation and mill) may have a negative effect. The question is: how far do we go in estimating the total effects of the project? The answer is that it depends on the situation in the country in question and the extent to which foreign exchange impacts is a critical consideration for decisionmakers.

In the example, table 3.10, derived from tables 3.4 and 3.9, provides the relevant information to answer the question. The table provides an indication of the net foreign exchange impact of the project alternative over time. What is judged to be acceptable depends on the particular circumstances.

No single measure can be recommended for measuring foreign exchange impacts. The simplest approach is to prepare a table showing the direct net inflows (outflows) of foreign exchange associated with the project over time (see table 3.10). A further step may be to discount the flows over time to provide a net present value of the effect. These types of tables include only the primary effects. Additional tables can be prepared showing estimated secondary effects, if appropriate multipliers^[5] are available. Such multipliers can be crudely estimated from previous experience, or they can be derived from input-output tables, if such are available for the country and/or region in question.

Table 3.9. Imported inputs and exported outputs at different times.

^a Import substitutes would also be included in this table.

Table 3.10. Balance of payments effects ($l,000/year).

Source: Tables 3.4 and 3.9.

Note: The inflow and outflow values could be discounted back to the present, using the social discount rate. This would provide a measure of the present value of direct net foreign exchange effect.

3.2 Methods for Answering Economic Efficiency Questions

As/stated earlier, economic efficiency analysis is needed to provide information on whether or not a project would provide an efficient use of the resources available to society as a whole. Three separate conditions reflect economic efficiency and these conditions can be treated as separate assessment questions. Put simply (as in the case of financial attractiveness), the relevant questions would be

1. Is the value of aggregate benefits greater than the value of the aggregate costs?
2. Is the value of benefits at least equal to the value of costs for each separable project component?
3. Is there any lower cost means available for achieving project objectives?

In all three cases, costs and benefits over time have been appropriately discounted to a common point in time, using the ARR as the discount rate.

The first step in answering any of the questions would be to identify which separable project components to include in the assessment, and the physical inputs and outputs related to those components. These inputs and outputs might be the same as those used in a financial analysis, or the analyst might choose to include new inputs or outputs which have economic but not financial value, since they are not traded in markets. The next step would be to generate a value flow table. This table differs from the cash flow table used to answer the financial questions in that it represents costs and benefits to society rather than to separate the interested parties. To shift from a cash flow table to a value flow table, three types of adjustment need to be made

1. estimate values of the added inputs and outputs that are not included in the financial analyses;

2. revalue some costs and benefits that are included in the cash flow table;

3. remove transfer payments such as taxes, subsidies, and loans from the cash flow table and adjust for differences in timing of economic and financial costs and economic benefits and financial returns.

Two measures are commonly calculated to assist in answering the economic efficiency questions: the NPV and the economic rate of return (ERR). In comparing mutually exclusive alternatives, the appropriate measure of comparison is the NPV. For ranking projects in a situation where a limited budget is to be allocated among not-mutually exclusive alternatives (i.e., capital budgeting), an appropriate ranking measure is the ERR. Chapter 6 describes both of these measures and compares them in more technical terms. Since in most cases decisionmakers are concerned both with the best design for a given project (mutually exclusive alternatives to achieve a given project objective) and with the problem of allocation of a limited budget to a number of projects, both measures should generally be calculated.

If the present value of project benefits exceeds the present value of costs, the project will have a positive NPV. If, in this case, the appropriate social discount rate is used to calculate present values, the project will also have an ERR that exceeds the social discount rate. Thus, either measure can be used to answer the economic efficiency question, both for the total project and its separable components.

In the forestry project example, table 3.12, derived from information in tables 3.4 and 3.11, provides the necessary information for calculating both the NPV and the ERR. The calculation techniques are straightforward.^[6]

The final question related to economic efficiency is whether or not there any lower cost means available for achieving project objectives? The first step in answering this question would be to identify the physical inputs and outputs (both direct and indirect) for each alternative project approach which yielded the desired outputs. Value flows for each alternative would be generated and the sum and NPV of aggregate costs calculated. This question might be used if decisionmakers have already decided to do a project, or if calculation of project benefits was not feasible, and the analyst is asked only to determine the least cost means to accomplish project objectives.

Table 3.11. Economic prices. ^a

^a Since only unskilled labor has a shadow price different from market traded price in our example, and since no nonmarket traded inputs and outputs were identified table 3.12 could have been eliminated. We have included it here for the sake of clarity.

Table 3.12. Total economic value flow table ($1.000/year^a).

Source: Tables 3.4 and 3.11.
^a In real terms, e.g., fixed 1980 dollars.