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Guidelines for the Economic Analysis of Projects : XIII. Sustainability of Project Effects
XIII. Sustainability of Project Effects154. Economic viability depends upon the sustainability of project effects. The economic analysis of projects should include an analysis of the financial sustainability of project agencies, and the environmental sustainability of outputs and inputs. The ENPV and EIRR measure the value of a project over its estimated full life. However, the transience in practice of some project effects has drawn attention to the way in which financial and environmental effects impinge on benefit sustainability. Postevaluation experience also shows that, unless such factors are taken into account, economic benefits will not be sustained at the level necessary to generate an acceptable EIRR. A. Financial Sustainability155. There are three aspects of financial sustainability:
Project Funding and Fiscal Impact156. A financial plan at constant financial prices is necessary to ensure there will be adequate funds to finance project expenditures. This applies to the implementation period to ensure capital funds are available to cover investment and working capital requirements, and to the operating period to ensure sufficient funds to cover operating expenditures. Where the project will generate revenue, this revenue will be the main source of funds during the operating period. 157. For indirectly productive projects that do not generate sufficient funds to cover operating expenditures, the full fiscal impact of the project for each year of its life should be calculated. The financial requirement becomes a fiscal requirement, and steps should be taken to ensure that the government commits adequate funds for operational purposes. Directly productive projects will also impact on the government budget, through tax revenues and concessions, and the net budget effect also can be calculated. The fiscal impact calculations should be linked to policy discussions over the extent and scale of user charges, operators fees, and tax revenues. 158. For many public sector projects the government budget will be the principal source of funds to meet investment and operating expenditures. These funds could come from different sources. One possible source is a reallocation from other public expenditure programs. Another source is efficiency improvements in other public expenditures. In either case, the additional project expenditure should be considered in the context of public expenditure policy as a whole. Where the funds are not met from reallocations or efficiency improvements, they will be met from extra taxation or from borrowing. The economic effects of extra taxes, in particular what are the likely sources and what disincentives might they create, can be assessed at the national level. The economic effects of extra domestic borrowing by government can also be assessed at the national level. In either case, it is important to consider particularly the effects of extra taxation or borrowing on the groups who are the principal project beneficiaries, especially when these are the poor. Cost Recovery159. The introduction or adjustment of user charges to finance project expenditures from project beneficiaries involves four important issues:
The basic principle behind user charges is that users should pay the economic cost of the good or service being provided. In practice, this does not happen in many cases for government services or utilities. The appropriate cost for users to pay is the marginal cost of providing the good or service in question. However, over the life of a project the marginal cost must include the additional investment costs of expanding supply. The average incremental unit economic costs of investment and operation, on the basis of the least-cost method of supplying a good or service, should be taken as the appropriate target for charging users. This long-run marginal cost should be calculated at future, rather than historic, costs of supply. 160. Three measures should be calculated and compared for each project or subproject producing an output for which charges can be levied, for example, port or water charges. These measures are:
The average incremental financial cost and the average incremental economic cost of supply should both be calculated using the economic discount rate of 10-12 percent. Where a project or project component stands alone, the tariff charged to the users should be related to the average incremental cost of supply for the service provided. Where a project extends an existing network, the tariff charged should be related to the average incremental cost of supply, but spread over existing, as well as new, users. In most cases, either situation will require an increase in charges from present levels. 161. The government may decide to regulate or set charges so that the full costs of supply are not met by users. For example, the government may decide that only the operation and maintenance costs of government services need to be met from user charges, but not the capital costs of the project or project component. If so, the grounds upon which this implicit subsidy is given, should be stated. The extent of the effective subsidy should also be calculated. The effective subsidy is the difference between user charges and the average incremental cost of supply. Any subsidy implicit in the level of user charges will have to be met from funds or resources elsewhere in the economy through the budget system. 162. Bank policy is to seek the elimination of subsidies over time where they are not justified or where they can be replaced by more effective measures, for example, income transfers. Subsidies may be justified on efficiency grounds in selected contexts such as for decreasing cost activities, or activities with substantial external benefits, or even to compensate some producers or consumers for the effects of other government policies. Targeted subsidies may also be justified, where necessary, to ensure access to a limited number of basic goods, that is, basic food, a basic quantity of water, basic education, and primary health care; or to provide a social safety net during a period of general economic transition. In all cases, the economic effects of financing a subsidy must also be assessed. The raising of user charges to cost recovery levels to eliminate unjustified subsidies must be pursued at the sector as well as the project level. 163. Where a project provides a range of services on the basis of joint costs, it may not be possible to identify the marginal costs for providing each service. In this case, an overall financial internal rate of return can be calculated for the activities as a whole, for comparison with the chosen discount rate between 10 and 12 percent. Where the financial internal rate of return at constant prices falls below the chosen discount rate, the extent of the financial subsidy can be stated by calculating the extent to which tariff levels would have to be increased to provide a financial internal rate of return at least equal to the discount rate. 164. A key issue in deciding on the extent of cost recovery is the structure of the tariff charged. Increases in charges will be more affordable for some users than for others. Maintaining a single average tariff, where costs are not fully recovered, in effect subsidizes those who are better off to the same extent as those who are worse off. Tariff structures can be designed to ensure that those who use the service more pay more, and, in general, that those who are better off pay more. 165. The introduction or increase of user charges may affect the scale of the investment to be undertaken and its organization. Charges provide a form of demand management where users react by adjusting their use to the level of charges. These effects can sometimes be estimated through the use of price elasticities of demand. It is uneconomic to provide capacity at a level that would exceed demand at future charge levels. Typically, charge increases would reduce the need for investment somewhat and may, in turn, influence the average incremental economic and average incremental financial cost of supply. Demand management of this sort is particularly important where governments lack investment and operating resources. User charges are therefore a means not just of recovering costs but of determining the overall scale of investment, and should be considered at the early stages of project design (see Appendix 22). Financial Incentives166. For a project to be sustained, each of the main participants should benefit from it. However, each also will have a certain standard against which to measure the expected benefits of project participation. A project statement of costs and benefits at financial prices can be constructed for the directly productive elements of a project, for example, the commercial farm, the port authority, the build-own-operate-transfer sponsor, or the tomato paste factory. This project statement also includes the effects of taxation and of loan funds. The basic test of financial sustainability is whether the financial internal rate of return for the project participant exceeds the opportunity cost of capital for that participant. This may also include a risk element where revenues are in the form of charges or fees negotiated with, or regulated by, the government. The economic analysis of the project should include a statement based on realistic assumptions about taxation and the real costs of borrowing on the financial returns to investors (see Appendix 23). 167. For some project participants, a full financial internal rate of return analysis cannot be undertaken. This will include the government, which may benefit from tax revenues unrelated to its proportion of costs. A statement of the effect of the project on the government budget should be included. It will also include small-scale participants whose investment is small or provided in kind, for example small landholders or tenants. Here a statement should be provided of the expected increase in annual income after allowing for any taxes, charges, and the real cost of borrowing. 168. In many cases, the sustainability of project effects will depend upon specific investors or public corporations. A statement should also be included of how the project fits into the overall corporate structure, and whether any restructuring is required. These issues should be followed up in more detail in the financial analysis of the project. Financial and Economic Analysis169. Project financial analysis should be undertaken in conjunction with project economic analysis. Financial prices influence the decisions of project participants; economic prices record the consequences of those decisions for the national economy. Financial prices help determine the level of demand for project outputs and the level of supply of project inputs. Prices or user charges, demand, and the scale of investment all need to be considered simultaneously. Financial prices provide the incentive for investment. For example, the extent to which traffic will divert to a new expressway, and the return to the expressway investor, will vary with the projected level of toll. The consequences of these responses for the economy as a whole are calculated in economic prices. The extent of traffic diversion will affect the level of traffic cost savings, and hence, also the EIRR of the project.
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