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p. 61 of 74 BACK | NEXT I. Introduction II. Background III. The Economic Rationale of A Project IV. Macroeconomic and Sectoral Context V. An Integrated Approach To Economic Analysis VI. Identification and Quantification of Costs and Benefits VII. Valuation of Economic Costs and Benefits VIII. Large Projects, Linkages, and National Affordability IX. Least-Cost and Cost-Effective Analysis X. Investment Criteria: Economic Viability XI. Discount Rate XII. Uncertainty: Sensitivity and Risk Analysis XIII. Sustainability of Project Effects XIV. Distribution of Project Effects XV. Projects and Policies XVI. Appendices Appendix 1: Key Questions For The Economic Analysis of Projects Appendix 2: Project Economic Rationale: Market and Nonmarket Failures Appendix 3: The Project Framework Appendix 4: Identification and Measurement of Consumer Surplus Appendix 5: Treatment of Working Capital Appendix 6: Depletion Premium Appendix 7: The Use of Constant Prices In The Economic Analysis of Projects Appendix 8: General Methodology For Building Up Project Statements Appendix 9: Economic Evaluation of Project Output and Input Appendix 10: Economic Price of Traded Goods and Services Appendix 11: Valuation of Nontraded Outputs and Inputs Appendix 12: Shadow Wage Rate and The Shadow Water Rate Factor Appendix 13: The Economic Price of Land Appendix 14: Treatment of Resettlement Components of Projects Appendix 15: Calculating Economic Prices At The Domestic Market Price Or World Market Price Levels Appendix 16: Estimating The Shadow Exchange Rate Factor and The Standard (Or Average) Conversion Factor Appendix 17: Example of An Economic Rate of Return: An Irrigation Rehabilitation Project Appendix 18: Effect On Net Foreign Exchange and Budget Flows: An Example Appendix 19: Least-Cost Analysis and Choosing Between Alternatives Appendix 20: Estimating The Economic Opportunity Cost of Capital Appendix 21: The Treatment of Uncertainty In The Economic Analysis of Projects: Sensitivity and Risk Analysis Appendix 22: User Charges, Cost Recovery, and Demand Management: An Example For Piped Water Appendix 23: Financial Returns To Project Participants: An Illustration Appendix 24: Economic Evaluation of Environmental Impacts Appendix 25: Distribution of Project Effects Appendix 26: Impact On Poverty Reduction Appendix 27: Difference Between Economic and Financial Prices Appendix 28: Use of Economic Prices In Measuring Effective Protection Appendix 29: Exchange Rate Issues In Project Analysis XVII. Others

Guidelines for the Economic Analysis of Projects : XVI. Appendices

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Appendix 19 : Least-Cost Analysis and Choosing Between Alternatives

1. Least-cost analysis aims to identify the least-cost project option for supplying output to meet forecast demand. The selection of the least-cost project from mutually exclusive, technically feasible project options promotes productive efficiency. By itself, least-cost analysis does not provide any indication of the economic feasibility of the project since even a least-cost project may have costs that exceed its benefits. Where least-cost analysis ends, benefit-cost analysis begins by comparing the cost stream of the least-cost solution with the benefit stream to determine whether the net present value is positive.

2. Least-cost analysis enables the ranking of mutually exclusive project options, alternative ways of producing the same output of the same quality. Since benefits are the same, it is necessary only to compare costs and to select the alternative with the lowest present value of cost, discounted by the opportunity cost of capital. Alternative options may consist of different designs, technologies, sizes, and time phasing of what is essentially the same project. A project alternative may also consist of the same project in an alternative location. Being mutually exclusive, the project options must be realistic, such that the selection of one project means the rejection of others. In comparing project options, least-cost analysis must be based on economic prices. In cases where the benefits of mutually exclusive projects are not the same, that is, there are differences in output or service quality, a normalization procedure must be undertaken to ensure equivalence.

3. For project alternatives that deliver the same benefits, it is possible to estimate the equalizing discount rate between each pair of mutually exclusive options for comparison. The equalizing discount rate (or the cross over discount rate) is the discount rate at which the preference changes. It is also the rate at which the present values of the two cost streams are equal.

I. Least-Cost Analysis: An Example

4. Consider a geothermal power plant with an aggregate capacity of 880 MW in 16 units of 55 MW each. The most technically feasible project alternative is a 900-MW coal-fired plant in 3 units of 300 MW each. Since the coal-fired plant generates a little more electricity than the geothermal plant, the cost stream of the geothermal plant is normalized by including the foregone benefits from the output differential priced at long run marginal cost. While capital outlays for the geothermal project start earlier than the coal project due to steamfield development, its operating costs are lower. The coal plants recurrent costs are much higher due to coal inputs. Table 1 presents the present worth of both project options at discount rates of 8 and 13 percent. The ranking of the geothermal and coal alternatives, based on the cost stream with the lowest present worth, may change between lower and higher discount rates. If the opportunity cost of capital is 8 percent, the geothermal project is selected. On the other hand, if the opportunity cost of capital is 13 percent, the coal-fired project with the delayed investment constitutes the least-cost option. Between 8 and 13 percent, the least-cost option changes from the geothermal plant to the coal-fired plant. The equalizing discount rate at which the switchover occurs is estimated at 10.1 percent. The equalizing discount rate is less than the hurdle rate of 12 percent. The additional costs of the geothermal alternative are not worthwhile. The coal-fired alternative should be chosen.

Notes:

1. Investment cost for Geothermal Plant includes steamfield development.
2. Costs streams are expressed in economic terms at constant prices.
3. With different plan factors, station use, and transmission losses, net power generation is the same, project options can be considered mutually exclusive projects with the same benefits.

II. Least-Cost Analysis: Average Incremental Economic Costs

5. Alternatively, if the effect or outcome of project alternatives is a homogeneous product of the same quantity and quality, the average incremental economic cost (AIEC) can be estimated. Consideration of the AIEC aims to establish the project alternative with the lowest per unit costs. The AIEC is the ratio of the present value of the incremental investment and annual costs to the present value of incremental output.

6. Selecting the least-cost option through a comparison of the AIECs can be illustrated by the following example. Table 2 presents the cost streams of two alternative water supply projects where the source of water for alternative 1 is surface water while alternative 2 involves drilling for groundwater. At a discount rate of 12 percent, alternative 1 is selected, being the least-cost option as indicated by the lower AIEC. However, the choice changes if the discount rate is reduced below 7 percent, when the AIEC for the groundwater option will be lower than for the surface water.

* Water supplied by the project is assumed to be distributed as follows: 70% sold and paid for, 10% sold but not paid for (bad debts), 10% consumed but not sold (nontechnical losses), and 10% technical losses. Water sales are therefore adjusted to include bad debts and nontechnical losses, i.e., water sales are adjusted by the ratio of water consumed (90%) to water paid for (70%) or 1.29 times water sales.

Notes:

1. All costs expressed in economic terms at constant prices.
2. Other costs include opportunity cost of water, depletion premium, and effluent costs.

III. Cost-Effectiveness Analysis

7. Least-cost analysis is applied to projects where the effects or outcomes can be quantified and priced. In other cases, where project effects can be identified but not adequately valued, project selection may be based on the results of cost-effectiveness analysis (CEA). The purpose of cost-effectiveness analysis is to find the means (activity, process, or intervention) that minimizes resource use to achieve the desired results; or in the presence of resource constraints, the means that maximizes results. In CEA, the objective of the process or intervention need not be expressed in monetary terms. It can be applied to any process or intervention, provided the objective is quantifiable.

8. For example, CEA may be applied in the health sector. However, quantifying the objectives of health sector projects in terms of a common denominator is not always easy, since the ultimate objective of health care is good health and long life. While a health sector project may aim to reduce the incidence of illness, death, or disability, illness and disability tend to vary in duration and severity. A common denominator is therefore necessary to assess the impacts of individual health disorders and the cost-effectiveness of various interventions.

9. In the health sector, project effects may be expressed in terms of disability-adjusted life years to estimate the burden of disease. In other cases, the concept of quality-adjusted life year or healthy life day is used. Cost-effectiveness may also be measured in terms of births averted as in population control projects. An important limitation of CEA is that a number of other interventions could also affect project outcomes. The project alternative under consideration needs to be separated from these other effects.

10. The procedure for calculating the health effects of health care programs assumes that the amount of health a society has is measured by the number of healthy life days its population lives as a proportion of the total potential number of healthy life days people could enjoy in the absence of disease. Where a person availing of service from a health care program can extend his or her healthy life by a year, there is a gain of 365 healthy life days. CEA involves the calculation of the ratio of the discounted present value of program costs to net health effects, as in the following illustration.

11. In improving a certain populations health status, a combination of vaccination programs and village health worker programs are being considered. The results of an epidemiological study reveal that a vaccination program is estimated to save between 50 and 75 healthy life days per vaccination while a village health worker program is estimated to save between 7 and 15 healthy life days per visit. Different program designs are compared, providing different combinations of vaccinations and visits and having different cost implications, as presented in Table 3. Since Program 2 is indicated to have the least cost at $4.71 per healthy life day, it is the most cost-effective solution.

VHW = village health worker
HLD = healthy life day

12. The most cost-effective solution is not necessarily the most effective. Program 2 is the most cost-effective solution, but Program 1 will save more healthy life days. The problem is that it will do so at a higher cost. The annualized cost of Program 1 exceeds that of Program 2 by $100,000. It generates an extra saving of 2,500 HLDs. The cost of the extra HLDs generated by Program 1 are therefore $40 each. If Program 2 can be duplicated or expanded, it will generate the most HLDs saved for a given budget. However, if there is a constraint on expanding one of the components of Program 2, for example, a shortage of village health visitors, then a decision should be taken as to whether the extra HLDs of Program 1 are worth the cost of achieving them.

13. Because of the uncertainty involved in forecasting future demand and the complex interrelationships between the cost of output and the price charged, least-cost analysis should be an iterative process. The analysis should also take into account the value of flexibility, that is, the ability to adapt to changing demand conditions. For example, in the case of uncertain demand in a water supply project, it may be more costly but preferable to consider postponing the start of construction until demand is more certain, employing more flexible technology, or staging construction. Adding capacity in small amounts gives the water enterprise flexibility, but is also more costly. Hence, it is important to be able to value this flexibility. One way to do this is to find out how much lower the capital cost of the smaller plant would have to be to make it the preferred choice. The economies of scale associated with the larger, cheaper option would have to be equal to, or greater than, that amount to make giving up flexibility of the smaller project economical.

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