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p. 70 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 28 : Use of Economic Prices in Measuring Effective Protection

1. The policy climate affects the productivity of project investments. Just as policies play an important part in shaping project performance, project analysis can help in shaping policy reform. Project economic work contributes to the identification of the best combination of policy, program, and project interventions consistent with government-facilitated, private-sector-led development. The incentives created by domestic policy can affect production and consumption. For sectors where there is a high degree of protection, caution should be exercised in projecting the current policy framework into the future. In this context, the difference between financial and economic prices provides a good understanding of the directions in which adjustment pressures will take prices that will be received and paid by a sector or a project.

I. Financial and Economic Rates of Return

2. Comparing financial and economic rates of return for a sector or project can throw light on the effects of policy reform. The ideal policy-investment mix is one that combines a high financial and economic rate of return relative to the cost of capital. If a project is viable at financial prices but not at economic prices, then the project transfers income from the economy to the project investors. However, in such a situation project sustainability may be jeopardized by policy reform aimed at encouraging a more efficient use of resources. If a project is viable at economic but not at financial prices, it would transfer income from investors to others in the economy, including lenders, consumers, and the government. However, such a project would not be sustainable in financial terms, and would require an explicit government subsidy or would go bankrupt.

II. Measuring Assistance

3. The level of assistance given to a project or sector, explicitly or implicitly, can be defined in terms of the economic net present value (ENPV) and the financial net present value (FNPV). The level of assistance is equal to (FNPV-ENPV), and the ratio FNPV/ENPV is called the project assistance coefficient (PAC). Basically, the PAC indicates the price effects of government policies or market structures on material outputs and inputs. It can also be extended to include the effects of taxes falling on primary factors of production.

4. The simplest form of assistance measure compares domestic financial prices of outputs with their equivalent economic prices. The ratio of the domestic market to the world market price shows the extent to which domestic policies protect domestic producers from the direct influence of foreign markets. However, the prices of inputs are affected by government policies as well as outputs. The effective assistance coefficient (EAC) can be calculated at the sector or project level. Like the direct comparison of financial and economic net present values, it takes into account not only assistance on outputs but also assistance on inputs. The EAC is the ratio of value added in domestic financial prices to value added in economic prices.

5. PACs and EACs can be expressed as percentage rates. When expressed as a rate, the EAC is termed the effective assistance ratio (EAR). The EAR measures the difference in value added measured at financial and economic prices in relation to the value added at economic prices. It is therefore defined as:

EAR = ((VA_dom VA_eco)/VA_eco) x 100 percent = (EAC 1) x 100 percent

where VA_dom is value added at domestic market prices, and VA_eco is value added at economic prices. The EAR gives an indication of the extent to which a particular form of production is favored or discriminated against by government policy. EARs can be calculated for different sectors or projects in a country. In some countries, the coefficients will in general be much higher than in others. However, where domestic prices differ from world prices anyway, it is the dispersion of the EARs around their mean value that is significant. If an EAR is greater than the average for the economy, then the sector or project is relatively protected. If an EAR is less than the average for the economy, then the sector is relatively unprotected.

6. The cost of assistance is generally passed on to users of a sectors or projects output. For example, where output prices are raised to compensate for tax effects on project inputs, the cost of the taxes will be paid by the consumers through higher financial than economic prices. Higher values for the EAR imply a transfer from users and suppliers to the producers. A higher value for the EAR generally implies a loss to consumers, including the poor. High EAR values across many sectors in an economy are inconsistent with policies to assist the poor.

III. The Effective Assistance Ratio: An Illustration

7. The accompanying Table 1 provides project information in a form suitable for calculating an EAR, and investigating some aspects of the effects of government policy on the level of protection. The table shows the value of project inputs and outputs in domestic market prices and in economic border prices. In general, domestic prices are higher than economic prices because of the effects of the general tax and subsidy system in the country. However, the inputs of pesticide and fertilizer are heavily subsidized. As a result, financial prices for these inputs are considerably below economic prices. In addition, the government has been concerned to provide incentives for expanded exports of cotton. The domestic price for cotton is set at a level higher than its economic price.

Economic values using world price numeraire.

8. Comparing value added at domestic and economic prices, the EAR shows a level of protection of 20.5 percent. In other words, the subsidized inputs and the output price incentive more than compensate for the effects of other factors tending to raise the cost of inputs in domestic prices.

9. This comparison does not allow for the costs of funding the input subsidies and output price incentives. The government has decided that it will eliminate the subsidies on pesticides and fertilizer. If this is done, and if there is no change in the quantity of cotton produced or in the quantity of inputs that are used, the effect will be to reduce the level of protection for cotton growers. The lower part of table 1 shows that, in these circumstances, the EAR falls to a 15.6 percent protection level. In this case, protection is sustained by the output price incentive, as well as by the tax and subsidy regime in general. Protection has been reduced by approximately one quarter by eliminating the input subsidies, but protection has been by no means eliminated.

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