Contents

I.  Introduction
II.  Background
III. The Economic Rationale of a Project
IV.  Macroeconomic and Sectoral Context
V.  An Integrated Approach To Economic Analysis
A.  Scope of Economic Analysis
B.  The Project Framework
C.  Financial and Economic Analysis
VI.  Identification and Quantification of Costs and Benefits
A.  General
B.  Identification and Quantification of Benefits
C.  Identification and Quantification of Costs
VII.  Valuation of Economic Costs and Benefits
A.  General Considerations
B.  Role of World Prices
C.  Economic Prices of Traded Goods and Services
D.  Economic Prices of Nontraded Goods and Services
E.  The Economic Price of Labor
F.  The Economic Price of Land
G.  Bringing Economic Prices To A Common Base
H.  Conversion Factors
I.  Economic Viability: A Procedure
VIII.  Large Projects, Linkages, and National Affordability
IX.  Least-Cost and Cost-Effective Analysis
X.  Investment Criteria: Economic Viability
A.  Project Decisions
B.  Choosing Between Alternatives When Benefits Are Not Valued
C.  Choosing Between Alternatives When Benefits Are Valued
D.  Testing The Economic Viability of The Best Alternative
E.  The Chosen Discount Rate
F.  Project Investments and The Budget
XI.  Discount Rate
XII.  Uncertainty: Sensitivity and Risk Analysis
XIII.  Sustainability of Project Effects
A.  Financial Sustainability
B.  Environmental Sustainability
XIV.  Distribution of Project Effects
XV. Projects and Policies
A.  Comparing Financial and Economic Prices
B.  Effective Protection Or Effective Assistance
C.  The Real Exchange Rate
XVI.  Appendices
Appendix 1: Key Questions For The Economic Analysis of Projects
Appendix 2: Project Economic Rationale: Market and Nonmarket Failures
Appendix 3: The Project Framework
Appendix 4: Identification and Measurement of Consumer Surplus
Appendix 5: Treatment of Working Capital
Appendix 6: Depletion Premium
Appendix 7: The Use of Constant Prices In The Economic Analysis of Projects
Appendix 8: General Methodology For Building Up Project Statements
Appendix 9: Economic Evaluation of Project Output and Input
Appendix 10: Economic Price of Traded Goods and Services
Appendix 11: Valuation of Nontraded Outputs and Inputs
Appendix 12: Shadow Wage Rate and The Shadow Water Rate Factor
Appendix 13: The Economic Price of Land
Appendix 14: Treatment of Resettlement Components of Projects
Appendix 15: Calculating Economic Prices At The Domestic Market Price Or World Market Price Levels
Appendix 16: Estimating The Shadow Exchange Rate Factor and The Standard (Or Average) Conversion Factor
Appendix 17: Example of An Economic Rate of Return: An Irrigation Rehabilitation Project
Appendix 18: Effect On Net Foreign Exchange and Budget Flows: An Example
Appendix 19: Least-Cost Analysis and Choosing Between Alternatives
Appendix 20: Estimating The Economic Opportunity Cost of Capital
Appendix 21: The Treatment of Uncertainty In The Economic Analysis of Projects: Sensitivity and Risk Analysis
Appendix 22: User Charges, Cost Recovery, and Demand Management: An Example For Piped Water
Appendix 23: Financial Returns To Project Participants: An Illustration
Appendix 24: Economic Evaluation of Environmental Impacts
Appendix 25: Distribution of Project Effects
Appendix 26: Impact On Poverty Reduction
Appendix 27: Difference Between Economic and Financial Prices
Appendix 28: Use of Economic Prices In Measuring Effective Protection
Appendix 29: Exchange Rate Issues In Project Analysis
XVII.  Others
Abbreviations
Glossary of Terms / 4
5
8
13
17
32
36
40
42
47
49
53
176

I. Introduction

1. These guidelines provide a general approach for the economic analysis of projects for application by the Asian Development Bank.1 While the guidelines focus on the objective of maximizing net output or income, which is often referred to as the "economic" or "efficiency" objective, they do so in a broad manner to ensure consistency with the Banks focus on

·  the social sectors and the environment, and

·  greater project and program support to develop institutions and organizations that facilitate economically efficient market activity in the Bank's developing member countries.

2. The economic analysis of projects includes an assessment of the sustainability of project effects to ensure that

·  the project provides sufficient incentives for producers,

·  sufficient funds are available to maintain project operations,

·  the least cost means of providing the project benefits is used,

·  the distribution of project benefits and costs is consistent with project objectives, and

·  environmental effects are included in the analysis (see Appendix 1).

______

1 These guidelines are a revision of the previous edition published in 1987. The revision draws on research undertaken by the Bank and other multilateral lending institutions.

II. Background

3. Several factors have combined in recent years to change the context within which Bank lending operations occur. The Report of the Task Force on Improving Project Quality (1994) recommended that the Banks guidelines and procedures for the economic analysis of projects be reviewed with the aim of strengthening project quality. At the same time, the Medium-Term Strategic Framework adopted by the Bank requires greater emphasis to be placed on social and environmental concerns. This has resulted in the need to widen the scope of economic analysis to account more fully for nonmarket benefits and costs.

4. Other factors include evolving changes in the theory and practice of development, and the role of the public sector; the related shift toward stronger support for environmental sustainability; and greater emphasis on organizational and institutional change and provision of social, legal, and institutional infrastructure to facilitate private economic activity.

5. The application of economic logic to the identification of appropriate investment operations and to the economic analysis of such projects derives from the prevailing views and theories on economic development, and on the most effective role for government in the economy. During the 1980s and 1990s, both of these bodies of theory experienced major and continuing change. Development is now seen less as a process of transferring physical capital, and more as assisting in human capital and institutional development. In economic management, government is seen as playing more of a facilitative, rather than a command and control, role. In particular, direct investment in government activities in industry, finance, and agriculture takes a decreasing share of the Banks loan portfolio. Instead, Bank investment in the form of loans and credits to these sectors is increasingly directed at facilitating private sector development.

6. The view that has emerged is that the facilitative role of government includes four primary sets of activities:

·  providing the institutional framework within which market-based transactions can expand and appropriate government investments can be rationally made, such as, political stability, commercial codes, legal systems, budgeting and control systems, consumer protection, and respect for property;

·  provision of an economic environment in which private investment can expand efficiently and equitably, for example, price and exchange rate stability, neutrality between sectors, access to global financial and capital markets, and access to export and import markets;

·  development and maintenance of human capital and technological capability, for instance, an educated and healthy workforce, access to technology, and ability to adopt and adapt; and

·  provision and maintenance of economic and social infrastructure, such as transport, communications, and health and welfare systems.

7. At the same time, project planning and project economics are now affected by environmental issues; various aspects of sustainability, including those of a financial, environmental, economic, social, and political nature; equitability; participation; and governance, including the role of women and nongovernment organizations in development. Economic analysis must facilitate the analysis of these additional issues whilst maintaining the basic focus on economic viability.

III. The Economic Rationale of a Project

8. The application of economic logic should occur early in the project cycle, rather than simply at the appraisal stage. It should lead the analyst to ask whether the investment operation being analyzed represents an appropriate role for government or whether a policy change or institutional change might be broader reaching and more sustainable than a proposed physical investment. The analysis of investment operations and the analysis of policy-based alternatives can flow from the application of the same forms of economic logic.

9. The inadequacy of markets to produce what society wants provides the main rationale for Bank operations. Where financial returns are less than cost recovery, or revenues are nominal or nonexistent, there is a case for financing public projects. Because external benefits and costs are not a part of financial production decisions, too little output will tend to be produced where externalities are net benefits, and too much where they are net costs (see Appendix 2).

10. Many goods and services are still produced in relatively monopolized markets, both by the public sector and by the private sector. Bank assistance should be combined with development of a legal and regulatory framework that limits the effects of monopoly structures. The extent to which competitive market structures can be created or simulated depends on transactions costs. Transactions costs include the costs of negotiating and enforcing contracts, and the costs of collecting charges for goods and services provided. The Bank can assist with the introduction of new technologies and institutional arrangements which reduce transactions costs and increase accountability. In some sectors, the Bank will therefore achieve a longer term aim of ensuring sustainable private production of both private goods and public goods.

11. The Bank seeks to provide finance primarily for public and near-public goods, and for those elements, such as roads, irrigation systems or enterprise restructuring, which help to create the conditions under which a larger number of goods can be produced as private goods. The two common criteria used to distinguish between public and private goods are

·  subtractability how much the consumption of a good or service by one person subtracts from the ability of others to use the good or service; and

·  excludability the extent to which a potential user can be excluded if the user does not meet conditions set by the supplier.

·  The Bank is also involved in reducing public bads such as environmental costs or poverty, and in funding some private sector developments where they can play a catalytic or demonstration role.

12. Bank operations must also cope with the consequences of nonmarket failure. Many projects, both private and public, underperform because they are not implemented and operated effectively and because the project benefits are captured by some groups, especially the nonpoor, and not by others. Nonmarket failure helps to explain why projects often yield higher costs and lower benefits than those forecast at appraisal. Bank projects and operations can reduce nonmarket failure through capacity building for strengthening organizational capacity, and for restructuring institutional roles in a sector.

IV. Macroeconomic and Sectoral Context

13. Project proposals should be derived from, and placed in the context of, broader development objectives. These objectives may be explicitly stated in a government plan document, or implicitly given through a public investment program. They will form the basis of the Country Operational Strategy Study. A statement should be given of the main development objectives of a country to which a proposed project will contribute. This statement is separate from the classification of projects according to the Bank's own system of priorities, and includes the time period in which specific objectives are to be achieved or programs of investment are to be implemented.

14. There will be constraints to the achievement of development objectives and implementation of sector programs. At the sector level

·  forecasts should be provided of future demands or needs for the type of output to be produced;

·  existing sources of supply, the costs of supply, and intended investments should be outlined;

·  a statement should be provided of the contribution of the proposed project to meeting sector demands or needs, and any cost reduction or technology innovation it may contribute; and

·  a statement should be provided of the extent of direct government involvement as a supplier and the extent of government subsidy to the sector.

15. Many investments will work well only if there are complementary investments in related sectors or activities. For example, for an irrigation project to raise agricultural output, the appraisal report must elaborate the necessary extra requirements for transport and processing. Projects to improve urban services should consider the capacity of the existing systems to deliver additional power and water. Potential constraints in supplies, whether they can be overcome, and the necessary timing of complementary investments, must be considered.

16. Because a project takes place within a given macroeconomic and sector context, an investment project can be seen as an incremental change to an existing structure. In fact, the context may be more important than the project itself. Moreover, a project that is financially sound within one sector and macroeconomic context may be financially unsound in another. Thus policy changes may be as important as the physical investment to the achievement of development objectives.

17. The macroeconomic and sector context will result in differences between financial and economic prices. The policy context that affects financial and economic prices can be analyzed on a country basis by determining

·  how levels for the key macroeconomic parametersexchange rate, interest rates, and wagesare determined;

·  the impact of microeconomic policies, such as import quotas, rationing schemes, and special financial incentives, on a particular investment;

·  which border policies, such as import duties and export subsidies, will affect project outputs and inputs and how; and

·  what are the existing market structures, such as the degree of monopoly supply and pricing for public utilities and other inputs, and the degree of competition for project outputs.

18. Brief statements on each of these four factors will focus attention on the macroeconomic and sector framework. Where any of the factors are deemed very significant, then the efficiency of project investments is likely to be reduced as consumers and suppliers respond to distorted prices. In addition, substantial differences between financial and economic prices as a result of any of these four factors can be a prelude to policy changes that increase the risk of project investments. Therefore, the statement of the macroeconomic and sector context should be accompanied by a statement on whether the intended investment project and associated policy dialogue are likely to facilitate adjustments in the framework or are likely to bolster resistance to change.