Catalog

	Table of Contents
p. 64 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

---

Appendix 22 : User Charges, Cost Recovery, and Demand Management : An Example for Piped Water

1. Competition for water is growing in many water basins throughout Asia. Urban and rural communities want more water than they can get. As water becomes scarce, polluted, and more costly to supply, investments in water-using projects must be looked at from an economic perspective. Water must be priced to minimize costs and maximize use values. This appendix sets out a method for evaluating pricing policies and demand management options that offset both the economic and financial returns from a project.

2. In theory, the efficient price of water would be determined by supply and demand, with the marginal willingness to pay for water equaling the marginal cost of supplying water. In practice, nonmarket situations apply with the government setting the price for piped water. Assuming that the increasing cost of supply is minimized and that willingness to pay is not distorted by government policies, the economic price charged for water should be set equal to the average incremental economic cost (AIEC) of supply, or, if the AIEC is below the average incremental financial cost (AIFC) of supply, the financial price should be set equal to the AIFC of supply. The AIEC of water is equal to the present value (at the economic cost of capital) of the stream of future capital and operating costs at real economic prices divided by the present value of the future quantity of water consumed (but not necessarily paid for). The AIFC of water is equal to the present value (at the financial cost of capital) of the stream of future capital and operating costs at real financial prices divided by the present value of the future quantity of water sold (and paid for). Both the AIEC and AIFC should be based on the long-term, least cost expansion path of the water enterprise.

I. Subsidy and Cost Recovery

3. Piped water is typically supplied as a public service at subsidized prices. The difference between the average financial price of water and the AIFC is referred to as the average financial subsidy. The difference between the average economic price of water and the AIEC is referred to as the average economic subsidy. The economic subsidy may or may not overlap the financial subsidy, depending on the magnitude of nontechnical losses, and the extent of market distortions and environmental costs and benefits. The ratio of the average financial price to the AIFC shows the extent of financial cost recovery and the ratio of the average economic price to the AIEC shows the extent of economic cost recovery.

II. Demand Management

4. The economic cost of subsidies paid to the piped water industry is often large. As a consequence of the high cost of subsidizing water, demand management can yield high economic savings, often much greater than the returns from supply expansion. The following example illustrates an approach to evaluating the economic merit of demand management relative to supply expansion. Depending on the price elasticity of demand, increasing the price of water will decrease the quantity of water demanded, increase sales revenue, cut back consumer surplus and operating costs, and, by postponing future expansion, reduce capital costs.

5. The example compares the benefits and costs of supply expansion, with and without demand management. Table 1 sets out the costs and benefits of expanding supplies when the price charged for piped water is below cost. Project costs are converted to economic prices using the domestic price numeraire. The net economic benefit is positive, providing a rationale for expanding supplies and paying the financial subsidy. Table 2 sets out the costs and benefits of expanding supplies and managing demand. Increasing the price of water by 27.5 percent results in the water enterprise achieving full cost recovery. At this higher water price the demand is lower and all the costs of water are recovered, including the opportunity cost of capital. However, investment has also been scaled down as a result of the lower projected demand. Allowing also for water that is used but not paid for, the scaling down of investment allows the AIEC to remain constant, at a level somewhat below the AIFC in this case.

O&M = Operation and maintenance

Table 2. Supply Expansion and Demand Management Option
(Financial Price equal to AIFC)

Notes:

1. Quantities in thousand m3 and costs in thousand units of local currency.
2. Quantity demanded is assumed to grow at an annual rate of 5%.
3. Capacity in Year 0 is sufficient for demand in Year 6.
4. Extension to the projects final capacity should be ready earlier in Year 5.
5. Cost (in Year 0) of supply expansion per m3 capacity is $1.50.
6. Cost of supply expansion in the future is assumed to increase by 50 percent.
7. O&M is assumed at 3.5 percent of investment cost and is assumed to grow annually by 4.0 percent.
8. Economic cost is greater than financial cost by 10 percent.
9. As part of water produced, revenue water is assumed to be 80 percent.
10. Economic opportunity cost of capital is assumed at 12 percent.
11. Coefficient of price elasticity of demand (assumed constant over time) is -0.40.
12. Annual quantity demanded as a result of price increase is calculated using arc elasticity formula (see Table 2):

Qt = Qt-1 * ((1 + eA/2) / (1 - eA/2)) where A = Pt - Pt-1 / ((Pt + Pt-1)/2) or 0.25

6. Without demand management the financial subsidy, the difference between the average price and the AIFC, is 0.11 or 21.6 percent of costs. With lower economic costs, but allowing for water that is used but not paid for, the equivalent economic subsidy is 0.05 or 11.1 percent. With demand management, the higher charge for water, lower demand, but also lower investment, reduces the financial subsidy to zero the full financial costs are being met. At this new charge level, because more water is consumed than paid for, the AIEC is lower than the AIFC and therefore lower than the charge for water. There is now a negative economic subsidy, that is, an implicit tax of 0.06 or 13.3 percent.

Back Appendix 21: The Treatment of Uncertainty In The Economic Analysis of Projects: Sensitivity and Risk Analysis	Next Appendix 23: Financial Returns To Project Participants: An Illustration