Introduction to Cost Benefit Analysis (CBA)

Transcription

1 Water Resources Management Good Practices and Knowledge Transfer - project component Introduction to Cost Benefit Analysis (CBA) András Kis

2 Basics Why do a CBA? To see if a decision (frequently an investment decision) makes financial sense. Are we better off eventually? Structured framework to understand the problem and the solution better To choose the best possible alternative How to do it? Sum all costs Sum all benefits Compare costs and benefits If benefits > costs, then there are net benefits, the investment is financially attractive. If benefits <= costs, the investment should be neglected (on financial grounds, at least)

3 Doing a CBA is extremely simple, isn t it? Quantifying some of the costs/benefits can be challenging. Multiple year time horizon needs to be handled. Examples What will be the value of saved electricity 10 years from now? What is the value of improved service (e.g. water service for 4 days a week, instead of 2 days a week) What is the value of extending the lifetime of a non-renewable aquifer?

4 Multiple year time horizon and discounting Can we accept that a Dinar today is not the same as a Dinar tomorrow? Do you expect interest to be paid if you deposit your money to a bank? Do you have to pay an interest if you take a loan? Interest: the charge for the privilege of borrowing money (time value of money) 100 JD placed in a bank for an annual interest rate of 5%. 105 JD in one year JD in two years (105*1.05) JD in three years (110.25*1.05) We can say that 100 JD today is the same as JD in three years time, assuming a 5% interest rate. Compounding takes place 5% interest rate compounded through 3 years becomes 15.76% (= )

5 Multiple year time horizon and discounting Calculating the present value of a future sum takes place through discounting. Mathematically it is the reverse of compounding. interest rate = 10% time horizon = 1 year future value = 200 JD present value = 200 / 1.1 = interest rate = 10% time horizon = 2 years future value in 2 years = 200 JD future value in 1 year = 200 / 1.1 = JD present value = / 1.1 = JD alternatively: present value = 200 / =

6 Example I have a contract to buy a car 1 year from today for JD 10,000. How much money do I have to deposit in the bank if I receive a 5% interest rate? 10,000/1.05=9,524 This is the present value of the future JD 10,000.

7 Multiple year time horizon and discounting interest rate = 10% time horizon = 10 years future value in 10 years = 200 present value = 200 / = JD In case of a multi year CBA all costs and all benefits should be converted to the same basis: present value or annualised value Interest rate used for discounting is also often referred to as discount rate.

8 Equivalent annual cost (annualisation) The annual cost of an asset or investment over its entire lifespan. Calculated by dividing the NPV of a project by the "present value of annuity factor Especially useful in comparing assets or investments which have different lifespans. The higher the interest rate (r), the higher the annualised value.

9 A simple example Buying new pumps to save electricity Investment cost: EUR 200,000 Annual electricity saving: 300,000 kwh Unit cost of purchasing energy: 0.05 EUR/kWh Useful lifetime of pump: 20 years (after that it would have to be replaced) Discount rate: 5% Annual saving: 300,000 kwh * 0.05 EUR/kWh = 15,000 EUR Present Value of annual saving: Net Present Value (NPV) of investment: Benefit - Cost = 186, ,000 = EUR -13,067 15, , , ,000 =186, Not worth it, but close. NPV may become positive, if discount rate is lower (cheaper financing) price of electricity increases useful lifetime of pump increases

10 The value of the discount rate depends on the source of financing Bank loan (whether soft or hard): the interest rate paid after the loan Own resources: the opportunity cost of investing money elsewhere, e.g. the rate of bank deposit. Grant from international organisations: zero interest rate Grant from the government: zero interest rate from the perspective of the water authority / water utility government borrowing cost (e.g. government bond interest rate) from the perspective of the government

11 Managing uncertainties Sensitivity analysis: looking at the impact of different variables. E.g. discount rate, lifetime, investment and operating cost Constructing and testing a worst case scenario If the net benefits are positive under worst assumptions, then all is clear for the investment. Some variables the future values of which are uncertain: exchange rate interest rate levels of costs (e.g. energy, labour) tax rates technical performance of an investment

12 How complex can a CBA become? Evaluation of the Gabcikovo- Nagymaros barrage system (dam to produce hydropower) Hydropower generation Peak and off-peak prices and operational modes Ecological damage due to peak operation Flood protection Inland navigation (but that also requires additional investments, e.g. ports and river regulation) Loss associated with wetland degradation Ground water resource degradation + time horizon of years

13 Thank you! شكرا