1 Chapter 2. Economic Analysis of Water Resources Daene C. McKinney 2.1 Cost – Benefit Analysis 2.1.1 Choosing Among Feasible Alternatives Economic analysis, or the understanding and prediction of decision making under conditions of resource scarcity, plays a major role in the planning, design and management of sustainable water resource systems. Allocation of water among competing uses to obtain an optimum value in terms of market or welfare measures is one of the main problems of water resources planners. Price theory is very relevant where markets are operating efficiently, whereas welfare economics seeks to maximize human welfare in situations where desirable social gains and undesirable social costs are not fully accounted for in a profit maximizing, market economy (North, 1985). Price theory and welfare economics tend to focus on static analyses of projects, whereas, financial analysis considers the time value of investments and decisions. In this section, we will consider some aspects of financial analysis. Choice is governed by economic and financial feasibility and acceptability with respect to social and environmental impacts. Here we want to consider investment analysis which serves as a guide for allocating resources between present and future consumption. The process consists of: Identifying alternatives to be considered; Predicting the consequences resulting from these alternatives; Converting the consequences into some commensurable units (e.g., $’s); and Choosing among the alternatives One project may produce one type of output, while another project produces another kind of output. In order to compare the projects and make investment decisions, common units must be used to express the outputs of each alternative before any comparison can be made. Monetary units are the most commonly used units. Some projects will provide outputs in the near future and other projects may delay outputs for an appreciable time or distribute them uniformly over the project lifetime. Outputs today do not have the same value as outputs tomorrow and the following observations are appropriate: • Investors often prefer early return on investments since it provides them with more flexibility in making future investment decisions; • Benefits and costs at different times should not be directly compared or combined, since they are not in common units; • Future benefits and costs must be multiplied by a factor that becomes progressively smaller for times further into the future. This multiplicative factor is called the discount rate and it has a great impact on the alternative selected; • Future benefits and costs are given more weight with lower discount rates and less weight with higher discount rates; and2 • Committing resources to one project may deny the possibility of investing in some other project. This brings up the question of opportunity costs, or what must be foregone in order to undertake some alternative. One should always keep in mind that different points of view may be adopted in analyzing alternatives, e.g., project sponsors; people in a specific area or region; and an entire nation. Each point of view may value benefits and costs differently and even define items differently (i.e., one person’s cost may be another person’s benefit.). 2.1.2 Cost-Effectiveness Analysis A program is cost-effective if, on the basis of life cycle cost analysis of competing alternatives, it is determined to have the lowest costs expressed in present value terms for a given amount of benefits. Cost-effectiveness analysis is appropriate whenever it is unnecessary or impractical to consider the dollar value of the benefits provided by the alternatives under consideration. This is the case whenever (i) each alternative has the same annual benefits expressed in monetary terms; or (ii) each alternative has the same annual affects, but dollar values cannot be assigned to their benefits. Analysis of alternative defense systems often falls in this category (OMB, 1992). 2.1.3 Benefit-Cost Analysis Financial benefit-cost analysis evaluates the effect of a project on the water sector or utility by providing projected balance, income, and sources and applications of fund statements (ADB, 2005). This can be distinguished from economic benefit-cost analysis which evaluates the project from the viewpoint of the entire economy. In financial benefit-cost analysis, which we will consider here, the unit of analysis is the project and not the entire economy nor the entire water sector or utility. Therefore, it focuses on the additional financial benefits and costs to the water sector, attributable to the project. Benefit – Cost Analysis is a systematic quantitative method of assessing the desirability of government projects or policies when it is important to take a long view of future effects and a broad view of possible side-effects (OMB, 1992). • Both costs and benefits of a project must be measured and expressed in commensurable units; • It is the main analytical tool used to evaluate water resource and environmental decisions; • Benefits of an alternative are estimated and compared with the total costs that society would bear if that action were undertaken; and • Viewpoint is important - some groups are only concerned with benefits, others are concerned only with costs In benefit – cost analyses, any costs and benefits that are unaffected by which alternative is selected should be neglected. That is, the differences between alternatives need only be considered.3 Estimates of benefits and costs are typically uncertain because of imprecision in both underlying data and modeling assumptions. Because such uncertainty is basic to many analyses, its effects should be analyzed and reported (OMB, 1992). Uncertainty may exist in: objectives, constraints, public response, technological change, or extreme events and recurrence. 2.1.3.1 Interest Rate Calculations Consider investing $100 at a rate of 5%. At the end of one year the value of the investment would be: 105$)05.01(100$1=+= F (2.1.1) Similarly, at the end of 2 years, the value would be 25.110$)05.01(100$)05.01(105$22=+=+= F (2.1.2) or,