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Part I: Scope of Project Economic AnalysisMacroeconomic ContextWhat macroeconomic factors influence target sectors and vice versa?A project cannot be designed and implemented in isolation from the rest of the economy. An understanding is needed of an economy’s overall performance and outlook and how macroeconomic factors may affect project performance. This includes understanding how the sectors of an economy contribute to the overall growth and development process and influence macroeconomic performance. Key macroeconomic factors include, for example, exchange rate changes that affect the price and competitiveness of traded goods, and economy-wide structural policies that influence prices and affect consumer and producer incentives and behavior. The fiscal management situation needs to be understood for the purposes of assessing and ensuring financial sustainability of projects that draw on public resources. Sector ContextWhat are the binding constraints to the functioning of markets and efficient and equitable provision of public services?Where markets provide private goods and services, dimensions of the sector setting that need to be understood include: key sector production and supply systems; prices and incentives that affect consumer and producer behavior, and; the supporting market and public institutional framework. Understanding is needed of: industry and market structures, conduct and performance; the global context of internationally traded goods and services; policy-caused price distortions (the main reason for differences between financial and economic prices); and assessment of private sector constraints that affect the function and performance of market-related institutions and determine the transaction costs of doing business, such as the legal and enabling environment. In cases where markets fail to provide goods and services that society wants, public provision can become a critical matter of inquiry. Understanding the role and performance of public institutions in, for example, service delivery requires equally careful assessment. This includes assessing the policy and legal framework, public goods delivery mechanism and performance, fiscal and public expenditure management, and the size and distribution of benefit incidence. As with the private sector, the organization and performance of public institutions can greatly affect the transaction costs in delivering public goods and services. Where public institutions and agencies fail to effectively provide public goods or deliver services, the causes need to be identified. Analysis of markets and public institutions provide the basis for problem identification, usually a market or institutional failure or imperfection. The sector analysis is the essential step to identifying key problems, their causes and effects, and consequently the basic rationale for a project and its objectives. Problem and objective tree analysis are established techniques in guiding a systematic diagnosis. The more clearly defined a problem and its causes are at the sector analysis stage, together with the objective for a possible project, the more focused project appraisal will likely be. Demand AnalysisHow much of the output is wanted? How much are users willing to pay for the output?A demand analysis provides the basis for identifying the goods and services needed by users and the estimation of the economic benefits from a project. A project that does not meet the consumer or user demand for particular goods and services will not meet its objectives, or generate benefits, resulting in resource wastage and non-viability. Market research and user surveys may be undertaken to increase the reliability of estimates and to assess the demand response to price changes and income growth. Research can also be used to identify the potential and options for beneficiaries’ willingness to pay for project goods and services. Project demand for an input and the market demand for an output or need for a service should also be assessed in the context of total demand and supply for the good or service, to determine whether total demand or supply, and prices, are likely to be affected by project output. Economic RationaleWhy should there be public sector intervention?The main rationale for public sector operations is to address failure or limitations of markets to adequately and efficiently provide what society wants. Market function imperfections can arise from, for example, sub-optimal market structures, and high transaction costs and risks due to unclear property rights, asymmetric information and poor contract enforcement. Missing markets can arise from the non-rival, non-excludable nature of goods and services that makes cost recovery and financially viable private provision difficult. Here, public provision is usually justified. Public goods include services such as public health, basic education and law and order. Imperfections and failures in public goods and service provision also arise. These include inefficient public provision that raises costs in relation to benefits, and leakages from intended beneficiaries (e.g. from the poor to the non-poor). Public institutions responsible for public goods and service provision may need strengthening through capacity building or restructuring. A clear economic rationale will help narrow the possible alternative ways of addressing a development problem, and help identify key performance indicators. Importantly, the basic economic rationale for a public sector operation is established at the time of sector assessment. Alternatives and Least-Cost AnalysisWhat is the best way of addressing the market or institutional failure or problem?Having established the problem to be addressed, and the rationale and objective for a project, the next question is what are the alternative, mutually exclusive ways to meet the objective? This includes asking what will happen without the project – that is, what is the counterfactual? Considerations include comparison of allocative efficiency and operational improvements with capacity expansions, and the scale, location, technology, and timing of alternative project designs. With the analysis on causes and effects of market and institutional failures in mind, the alternatives analysis can better consider alternative designs, institutional and financing arrangements. The basis for selecting the preferred alternative should be clearly explained, particularly if it is not the least-cost alternative in economic terms. Comparing Benefits and CostsWill the project benefits exceed project costs?With the project alternative selected, the next step is to determine whether the project is worthwhile, by comparing the costs with the benefits. The benefits of the project must be identified and measured relative to what might happen without the project, or the counterfactual. The without-project scenario need not be the same as the current situation. For example, if the current situation is expected to deteriorate further, the project impact must be measured relative to falling performance. Once the project’s inputs, and related costs, and outputs, and related benefits, are identified they need to be measured in physical terms and the unit and total value estimated. Estimate valuation must distinguish between project inputs and outputs that replace current supplies (non-incremental), or add to total supplies (incremental) as different methods apply. External effects, such as environmental impacts as a result of the project, must also be quantified, valued, and costs or benefits incorporated. The price level, either the domestic or world levels, and the unit of account (numeraire), either domestic or an international currency, must be consistently used in comparing alternatives. The without-project scenario should be the same one analyzed in the alternatives. The economic justification of the project is based on comparing the values of the benefits and costs. A project investment is economically justified if the estimated economic internal rate of return (EIRR) exceeds the economic opportunity cost of capital (EOCC) for the country. Given the difficulty of estimating country-specific EOCCs, the EOCC for all ADB DMCs is 12 percent. An EIRR between 10 and 12 percent is acceptable if there are significant unquantified net benefits. If the value of a project’s outputs cannot be measured, then the economic analysis can be based on a cost-effectiveness analysis. A project is cost-effective if it has the lowest average cost per unit of output. A cost-effectiveness analysis alone, though, is not sufficient. If benefits cannot be estimated, other economic and social arguments must be developed to establish the project’s justification. Financial and Institutional SustainabilityAre there enough resources to ensure the flow of project benefits?Project economic viability depends on and thus calls for detailed financial and institutional sustainability analysis. For example, financial sustainability assessment for revenue-generating projects incorporates an analysis of the financial performance of project related enterprises. A key assessment is whether there is sufficient incentive for respective project participants from a financial returns point of view, and whether participants have sufficient funds for investment, operation and maintenance. Where relevant, analysis is also needed of the self-financing capacity of the project-operating entity through prices or user charges. For both revenue and especially non-revenue generating projects, the fiscal impact of the project should be carefully considered. Where goods or services are funded directly through the government budget, an assessment of the fiscal impact of the project arising from, for example, operation and maintenance should be made. ADB supports minimal use of financial subsidies. Exceptions may occur in the provision of basic foodstuffs, basic water, primary health care, and basic education, but clear justification for financial subsidies needs to be established. Assessment of institutional sustainability focuses on identifying the functions, form and capacity of agencies, whether public, non-government or private, that are being considered for a role in implementation. A clear and distinct role for public and/or private agencies will need to be established based on systematic assessment of institutional factors that might underlie the market or institutional failure, and capacity to assume an identified role. The envisaged project implementation period should also consider the capacity of implementing agencies to achieve time targets, as delays can result in increased costs and delayed benefits. Distribution AnalysisWho benefits from this project, and by how much?The main project beneficiary and stakeholder groups and the extent to which they gain from benefits, or bear costs, should be identified. Where project effects are intended to benefit a target group, the proportion of net benefits going to that group should be assessed. Sensitivity and Risk AnalysisWhat are the chances that the benefits and costs will be realized as anticipated?As there is always a degree of uncertainty about future events, it is necessary to understand the parameters in an economic analysis that are subject to risk, the source of those risks and the probable extent of variation. Sensitivity analysis is undertaken to identify those parameters that are both uncertain and for which the project decision, taken through the economic net present value (ENPV) or EIRR, is sensitive. Switching values showing the change in a parameter required for the project decision to change from acceptance to rejection are presented for key parameters and can be compared with post-evaluation results for similar projects. A quantitative risk analysis is recommended for large projects, those projects with an EIRR close to the 12% EOCC, and those with high risks. The analysis should incorporate different ranges for key parameters, and the likelihood of their occurring simultaneously. Sensitivity and risk analysis should lead to improved project design, and an outline of actions mitigating against major sources of uncertainty. Monitoring and EvaluationDo the initial assumptions maintain their validity throughout the project life?The economic analysis often has to make assumptions about key parameters. Monitoring is needed of actual outcomes for the purposes of managing implementation and assessing impact. This is especially important for the increasing number of process type projects that do not identify, for example, specific production models in advance, as well as sector projects for which only indicative models may be appraised. ADB’s Project Performance Monitoring System (PPMS) provides the framework for laying out key parameters that require monitoring through appropriate data collection systems both as indicators in themselves and as inputs for on-going analysis. Analysis can inform the need for course changes and assessing real-time or ex-post impact.
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