SIXTH FRAMEWORK PROGRAMME
Project no: 502687
NEEDS
New Energy Externalities Developments for Sustainability
INTEGRATED PROJECT
Priority 6.1: Sustainable Energy Systems and, more specifically,
Sub-priority 6.1.3.2.5: Socio-economic tools and concepts for energy strategy.
Deliverable 4.1 - RS 3a
“Cost-benefit analysis –
Review of the Methodology and Practical Step-By-Step Guidelines for Applications in the Energy Sector”
Due date of deliverable: August 2009
Actual submission date: March 2009
Start date of project: 1 September 2004 Duration: 48 months
Organisation name for this technical paper: CUEC, UBATH and SWECO
Authors: Jan MELICHAR, Milan Ščasný, Alistair HUNT, and Ståle NAVRUD
Project co-funded by the European Commission within the Sixth Framework Programme (2004-2008)Dissemination Level
PU / Public / x
PP / Restricted to other programme participants (including the Commission Services)
RE / Restricted to a group specified by the consortium (including the Commission Services)
CO / Confidential, only for members of the consortium (including the Commission Services)
Executive summary
The three parts of this report: i) review the theory and methodology of Cost-Benefit Analysis (CBA), ii) describes a practical nine-step guideline to CBA, and iii) applies the guidelines to an energy investment project.
The aim of a CBA is to identify (to society) all advantages (social benefits) and disadvantages (social costs) of a project and its alternatives, compared to the “without project” situation (reference alternative); and monetize, aggregate (over all affected interest groups/stakeholders over the lifetime of the project), and compare them to see if social benefits exceed the social costs. Finally, to identify the project alternatives which have highest benefits compared to the costs over time; i.e. highest net present value.
The practical step-by-step guideline to CBAS consist of 9 steps:
1. Define the project and specify project alternatives/options, and the reference alternative they their costs and benefits should be compared to
2. Decide whose benefits and costs should count; i.e. identify the affected interest groups
3. Catalogue the impacts and select measurement indicators
4. Predict the impacts quantitatively over the life of the project
5. Monetize all impacts; including environmental and health impacts
6. Aggregate and discount benefits and costs (over time) to obtain present values
7. Compute the Net Present Value (NPV) of each project alternative
8. Perform sensitivity analysis
9. Make a recommendation
To illustration the use of this nine-step guideline to CBA, we added an application to alternative coal combustion technologies to replace coal fired units of existing power plants that are near to the end of their service life in the Czech Republic The status quo was defined as putting in coal-fired units with powdered coal burners. Benefits and costs of the Status quo and the four project alternatives are calculated compared to a reference alternative where no investments would take place. Table ES-1 present the results in terms of the Present Value (PV) of the costs and benefit components, and the Net Present Value (NPV) of the project alternatives. We see that both fluidized bed combustion systems (FBC- Brown and Biomass) provide negative NPV and are not profitable from the society´s point of view. The Combined heat and power system (CHP), integrated gasification combined cycle (IGCC), and powdered coal burners (Status quo), however, provide positive NPV and are profitable. Out of these, the best option is CHP which provides the greatest NPV. Thus, the contribution of this CBA to the decision-making process would be to recommend CHP as the most profitable/efficient coal combustion technology. Table 2 also shows the effect of the inclusion of external costs when calculating the NPV. The ranking of project alternatives when the NPV is based on the full social costs (= Private Costs + External Costs) is different from the NPV based only on private costs. This clearly shows the importance of including external costs.
Note, however, that there could be other coal combustion technologies than those considered in this example (e.g. with carbon capture and storage), or technologies utilizing other energy sources than coal, which could be more profitable than the alternatives in table ES-1. This illustrates the fact that our recommendation from a CBA is dependent on, and limited by, the definition of the decision problem /project and project alternatives we analyse. However, NEEDS provides external cost estimates that makes it possible to analyse and compare different technologies for many energy sources in CBAs.
Table ES-1.
Present Value (PV) of Costs and Benefits of Project Alternatives (in mill. €; 2005 price level)
Status quo / FBC brown / IGCC / FBC biomass / CHPPV Investment costs / 300 / 318 / 494 / 340 / 339
PV Operating costs / 387 / 389 / 475 / 499 / 395
PV External costs / 1340 / 1891 / 737 / 1867 / 1289
PV Benefits / 2070 / 2070 / 2070 / 2070 / 2537
Net Present Value (NPV)
= PV (Benefits) – PV (Total Costs) / 44 / -527 / 365 / -635 / 514
Ranking according to NPV including external costs / 3 / 4 / 2 / 5 / 1
Net Present Value (NPV)
= PV (Benefits) – PV (Private Costs) / 1383 / 1363 / 1101 / 1231 / 1336
Ranking according to NPV excluding external costs / 1 / 2 / 5 / 4 / 3
These guidelines provide the reader with a step-by-step procedure on how to conduct Cost-Benefit Analysis (CBA), with an application to energy production projects and their external costs. These practical guidelines are not intended to replace existing CBA textbooks and administrative guidelines. Rather, they are intended to complement existing guidelines as a practical guide for those who need to take account environmental and health impacts (external costs) of energy production in their economic analysis.
Table of content 4
Part I Review of Methodology
1. Introduction to Cost-Benefit Analysis (CBA) 5
1.1 Definition of alternatives 6
1.2. Consumer Benefits| 6
1.3 Impacts on Suppliers and Government 7
1.4 Producer surplus 7
1.5 Investment Costs 8
1.6 Taxation and government revenue effects 8
1.7 Cost Benefit Analysis Parameters 8
1.8 Risk and Uncertainty 9
1.9 Reporting the Cost Benefit Analysis 9
2. General issues 10
2.1 Non-market valuation techniques 10
2.2 Value transfer 13
2.3. Treatment of non-monetized values 15
2.4 Discounting and intra-generational equity issues 16
2.5 The project appraisal evaluation period 20
2.6. Decision criteria 20
2.7 Treatment of future risk and uncertainty 24
2.8 The Marginal Costs of Public Funds 26
2.9 Recommended Accounting procedures 27
PART II Step-By-Step Guidelines to CBA
1. Introduction 29
1.1. Purpose of the guidelines 29
1.2 Who should use the guidelines? 29
1.3 When to use the Cost-Benefit Analysis? 29
2. Main Steps in Cost-Benefit Analysis (CBA) 31
2.1 Specify the set of alternative projects 32
2.2 Decide whose benefits and costs count 35
2.3 Catalogue the impacts and select measurement indicators 36
2.4 Predict the impacts quantitatively over the life of the project 39
2.5 Valuing relevant costs and benefits 41
2.6 Discount benefits and costs to obtain present values 48
2.7 Compute the net present value of each alternative 50
2.8 Perform sensitivity analysis 54
2.9 Make a recommendation 58
3. Concluding comments 58
4. Main Steps in Cost-Benefit Analysis (CBA) 59
PART III Application of CBA Guidelines to Energy Investments
1. Specify the set of alternative projects 61
2. Decide whose benefits and costs count 62
3. Catalogue the impacts and select measurement indicators 62
4. Predict the impacts quantitatively over the life of the project 63
5. Monetize all impacts 64
6. Discount benefits and costs to obtain present values 65
7. Compute the net present value of each alternative 65
8. Perform sensitivity analysis 66
9. Make a recommendation 67
References 68
Part I Review of Methodology
1. Introduction to Cost Benefit Analysis (CBA)
A key aim of an economic appraisal of a project or policy is to measure the magnitude of the economic impact resulting from the investment. Ideally this would measure the total benefits from increased output across all final product sectors and would include measurement of the level of employment and the wage rate in the labour market, the prices of goods and services in the product market and the value of property in the land market. In practice, however, the analytical models required to undertake such an analysis require a level of sophistication and refinement that is typically beyond that available from both technical and resource standpoints. As such the Cost Benefit Analysis (CBA) process is based around a partial equilibrium approach[1] that concentrates on the “primary” impacts incurred. The basic calculation is summarised below:
Overall Economic Impact / = / Change in benefits (Consumer Surplus) / + / Change in system operating costs and revenues (Producer Surplus and Government impacts) / + / Change in costs of externalities (e.g. environmental and health impacts) / - / Investment costsThis apparently simple calculation can in fact become a quite complex exercise as it becomes necessary to consider:
· The scope of the appraisal;
· The definition of the alternatives – particularly the reference case or the Do Minimum scenario;
· The calculation of benefits (consumer surplus);
· The calculation of impacts on providers and the government (producer surplus and investment costs);
· Monetary valuation of non-market impacts;
· The mechanics of the process including inputs, project life, discounting, aggregation of benefits and costs, unit of account.
At the start of the CBA process, a view will need to be taken on the scope of the analysis. This is often made simultaneously with the decision regarding the type and scale of the demand forecasting approach, as the two processes are inter-related. Ideally, the CBA process should include all impacts of the investment, no matter how small that impact is. However, setting such a broad scope for a CBA will result in extensive data collection and analysis that may well be expensive in terms of cost but also in terms of time required to complete, both will affect the ability to deliver the project. Given that the purpose of the CBA is to firstly ensure that a project is economically beneficial and secondly to aid the choice between alternatives, the scope of the CBA is in practice often narrowed by excluding minor or insignificant impacts as long as the exclusion of these impacts will not bias the appraisal. Key issues that require addressing in defining the scope of a CBA include:
Impacts: the measurement of changes in producer and consumer surplus requires the measurement of benefits, revenues and costs.
Study area: should be the smallest area that allows for the development of robust results. It should therefore be large enough to capture network effects that include firstly the abstraction of demand from other projects and secondly the impact of competing and complementary schemes that in combination with the project in question may comprise the country’s development strategy. If cross-border impacts are expected then the study area should be defined so as to incorporate both.
1.1 Definition of alternatives
An environmental project or policy is normally proposed as part of a planning process to solve a set of specific problems or to achieve certain objectives. As such there is usually a range of solutions or alternatives that require appraising. These alternatives are termed “Do-Something” scenarios. To ensure that the different scenarios can be compared against each other it is important to undertake the appraisal against a single reference case scenario which is termed the “Do-Minimum”. The Do-Minimum scenario is defined as the scenario which involves carrying out as little investment as possible.
The Do-Something scenarios are easier to define as they represent the ‘solutions’ designed to solve existing problems or to achieve a set of local, regional, national or supranational objectives. Some complexity can occur in their definition when several inter-linked projects are proposed. One of the ways of handling such cases is to carry out appraisals of the bunched investment and of each of its individual components, to reach an optimal project selection and implementation programme.
1.2 Consumer Benefits
The essential measure of benefits to users is consumer surplus, that is, the excess of consumer willingness to pay over the cost of a good/service. Normally, we are interested in the change in consumer surplus resulting from some change in the cost brought about by an improvement in environmental conditions. For most consumer goods the cost of the good (to the consumer) is its price.
Box 1 describes the concept of consumer surplus measure of user benefits. The light shaded area in Figure 1 is known as the Rule of a Half measure of user benefits, for reasons discussed in Box 1. The Rule of a Half can also be applied separately to each of the user benefit impacts to provide a disaggregation by time, money costs and cost savings. Such a disaggregation will most likely be required for presentation of the cost benefit analysis results.
1.3 Impacts on Suppliers and Government
Although the consumer benefit analysis will often be the most testing part of the cost-benefit analysis, it needs to be undertaken alongside an analysis of revenues and costs which impact on both the suppliers and the government.
1.4 Producer surplus
Cost-benefit analysis is concerned not only with consumer surplus, but with total social surplus. This includes producer surplus (PS) as well as consumer surplus. Producer surplus is defined simply as total revenue (TR) minus total costs (TC):
PS = TR-TC and therefore ΔPS = ΔTR – ΔTC
Box A.: Consumer Surplus and the Rule of a Half
In Figure 1 an improvement in supply conditions, between locations i and j is shown. The fall in costs have effects on two groups of users:(i) Existing consumers – they gain the benefit of the cost change (C0 – C1) each, or area C0AEC1.
(ii) New consumers – they gain a benefit equal to the excess of their willingness to pay over their cost, or area ABE.
User benefits are the sum of (i) and (ii) and can be written:
(C0 – C1) T0 + ½(C0 – C1)(T1 – T0)
or
½ C0 – C1) (T0 +T1)
This is rule of a half measure of user benefits.
The rule of a half formula assumes the demand curve is linear between points A and B. Therefore, it is only an approximation to the true benefit – the more convex (or concave) the demand curve, and the larger the cost charge, the less accurate the approximation will be. Given the many sources of error in practical appraisal work, the rule of a half is considered acceptable except in cases where cost changes may be considered “large” relative to base cost levels.
Revenue forecasts will be needed both for the Cost Benefit Analysis and for the assessment of financial sustainability of projects. There may be a trade off in tariff-setting between the desire to maximise social benefits from the project and the imperative to satisfy budgetary constraints.