Catalog

	Table of Contents
p. 39 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 A. Comparing Financial and Economic Prices B. Effective Protection Or Effective Assisstance C. The Real Exchange Rate XVI. Appendices XVII. Others

Guidelines for the Economic Analysis of Projects : XV. Projects and Policies

---

XV. Projects and Policies

188. Investment projects take place in an economic environment shaped by government policy. Increasingly, governments are using market mechanisms in conjunction with investment projects to achieve their objectives. There are important relationships between policies, sector programs, markets, and projects.

189. Most investments funded or supported by government play an enabling role in the wider economic framework. The provision of physical infrastructure and an appropriate institutional framework allow producers of goods or services to adjust their activities to achieve higher levels of real income and other more direct benefits. These adjustments rely on additional activities, the supply of inputs, or the selling or distribution of outputs, also adjusting themselves to the new opportunities. In some cases, these adjustments will be easier to achieve than others.

190. Governments also act where market mechanisms produce ambiguous results. Relying on private investment and commercial credit to build up the productive sectors may be successful, but at the same time it may involve a displacement of labor from other sectors and an increase in income disparities. The government may want both to facilitate this process, through reallocation of water, health, and other government services, and to compensate for some of its effects, for example by promoting projects in outlying regions and activities where people remain poor. Investment projects are one means of both promoting the growth of incomes and services in the country and ameliorating some of the effects of this process. Project analysis can help in shaping sector and national policies, as well as providing the means of implementing them.

A. Comparing Financial and Economic Prices

191. Comparison of project rates of return at financial and economic prices, or the financial and economic costs of indirectly productive projects, can reveal the effect of current policies on investments within the sector. Ideally, projects will provide an adequate economic rate of return and a sufficient financial return to the main participants. However, cases will arise in which a project appears favorable to producers, but does not appear to be economically viable; and cases in which an economically viable project does not provide sufficient incentive to project participants. For each project, the basic question should be asked: Why do the financial and economic prices differ?

192. Generally, there are some factors that account for a small part of the differences. This can be the level of wages in the project, which may be above the opportunity cost of labor. However, for most projects this would not provide the main difference between financial and economic values. It could also be the effect of monopoly pricing of certain inputs, in transport, distribution, and construction, for example, which increases project costs. Where pricing of utilities and other services is a major cause for financial and economic prices to differ, then an appropriate system of regulation should be considered, in the case of autonomous suppliers, and a reduction in subsidy levels, where prices are low.

193. In most cases, it is the level of domestic taxes and subsidies, and trade taxes and controls, that cause financial and economic prices to differ. Differences in costs at economic and financial prices occur because of subsidies and taxes on input supplies. Differences in the value of traded outputs occur because of the levels of trade taxes and controls. There may be significant differences between the financial and economic price of foreign exchange because of government management of the foreign exchange market. Identifying these differences is part of the process of analyzing the distribution of project benefits. It is the first step in linking project investments and policy changes (see Appendix 27).

194. Where significant differences do exist between financial and economic prices, the question should be asked whether the underlying policies are likely to change during the life of the project. This is particularly the case for private sector projects, or projects that basically stimulate private sector activities: commercial returns that rely on significant differences between financial and economic prices indicate an additional risk of possible policy changes. If the government is planning for a reduction or standardization of tariff levels on imports, this should be built into the project estimates. If the government has already adopted a policy of reducing subsidies in utilities provision, the effects of this on the financial returns to project participants should be considered. A key question relates to exchange rate management and future levels of the real exchange rate (see Section XV.C below).

195. Conversely, analyzing the differences between financial and economic values for a project may suggest desirable changes in government policy, such as:

• actions that are specific to the project; or
• general changes in sector or national policy.

Project-specific actions include additional access to concessional credit to promote worthwhile projects, foreign exchange retention or access to foreign exchange at a favorable exchange rate, or meeting the costs of staff training. General changes in sector policy might include raising the target for cost recovery, applying competition policy in the sector, reducing the level of net protection through taxes and subsidies, and changing the administered or regulated prices. The main difficulty with these broader policy changes is that they will impinge on all existing producers and consumers in the sector, not just on those involved in the project.

Back XV. Projects and Policies	Next B. Effective Protection Or Effective Assisstance