Economic, Social And Environmental Cost Benefit Analysis

Economic and Social Cost Benefit Analysis Dr. Tarun Das, Professor (Public Policy), IILM, New Delhi-110003. EMAIL: [email protected]/ [email protected] 1. Introduction After examining the technical feasibility of a project, it needs to be examined whether the project is financially viable, economically sustainable and socially desirable. Accordingly, there are three basic cost-benefit appraisal techniques, depending on the purpose of the project, the methods for project financing, policies for recovering of costs and fixing of charges from the users. These methods stand as follow: (a) Financial cost-benefit analysis (b) Economic cost-benefit analysis and (c) Social cost benefit analysis. The traditional financial cost-benefit analysis deals with actual financial transactions and makes orthodox commercial analysis on the basis of market prices of products and all factors of production. It does not deal with the questions of distributional equity and does not make an analysis of the impact of externalities. The financial analysis generally estimates the cost/ benefit ratio (CBR), net present value of benefits (NPVoB) and the Internal Rate of Return (IRR). In the economic cost-benefit analysis, instead of market prices, the appraisal is based on the economic costs or the resource costs or opportunity costs of the both factors of production and the inputs. This is done on the basis of the following two adjustments in the financial cost-benefit analysis: (i) All costs are netted out of all taxes, duties and subsidies. (ii) The scarce and surplus factors are shadow priced. One attaches shadow prices to labour, energy and foreign exchange cost to take care of their either scarcity values or slack values. In general, shadow prices for scarce items (i.e. items with excess demand) will have shadow prices higher than their market prices, whereas items with excess supply (for example unskilled labour) will have shadow prices lower than their market prices. Social cost benefit analysis goes further beyond the financial and economic costbenefit analysis, and deals with not only efficiency pricing but also takes care of distributional equity and impact of externalities on the project. The two most prominent methodologies, which address these issues in a systematic way, are the UNIDO (1972) and Little Mirrelees (1968, 1974) book on projects appraisal. Continual discussions and debates on these two approaches have led to a vast literature on refinements and synthesis of techniques, and more sophistication in comparison with the conventional commercial profitability analysis. 1

2. Project Appraisal Techniques Given limited public resources and competing sectors needing public funds, it is necessary to make a comprehensive analysis of social costs and social benefits of a project and to bring its coherence to the list of investment projects. What is needed for that is a technique that would rank projects in order of their economic desirability, so that they could be adopted in rank order until the investment budget is exhausted. Previously, development economists had argued the merits of different criteria for deciding on project investment - the degree of capital intensity, the rate of reinvestment, the internal rate of return, the cost/benefit ratio, the size of the externalities and so on. The integration of these various investment criteria within a single procedure of appraisal of net present value was the work of Little and Mirrlees. A major issue of project appraisal is to measure the true cost of transferring a marginal unit of rural labour to urban employment, rather than assuming (as Lewis did) that the transfer is costless. At the same time, the valuation of a project’s non-labour inputs and outputs also pose difficult problems. They are due to the interventions by the governments that affect price formation in both rural and urban areas. For example, procurement of Foodgrains at minimum support prices by the government pushes up market prices, while supply of subsidized Foodgrains through ration shops puts downward pressure on market prices. Thus determination of market price is a complex issue. In any case, they are deviations from the market-clearing prices in a perfectly competitive market. These deviations are referred to as price distortions, but the idea of a price distortion makes sense only relative to some standard of undistorted prices. Little and Mirrlees proposed ‘world prices’ as their ‘sheet anchor’, but there are skepticisms among the economists, as there is no single “world price”. However, the use of world prices as a norm markes a significant shift in economic thinking about development, even though in practice the social cost-benefit appraisal techniques are scarcely more successful that the financial cost benefit analysis or economic appraisal of projects. The social cost benefit appraisal procedure for projects is very complex, even with short cuts. Moreover, no procedure can preclude opportunities for manipulating the numbers to give the result that political masters would like to have on non-economic considerations. Moreover, there is a more fundamental problem. The SCBA technique is an attempt to use ‘shadow’ prices to select investments, that is, to invest as if free market prices ruled, when in fact they do not. It is well known that perfect competitions is a utopia and does not exist in reality. The real world is neither competitive nor perfect. Investments chosen on the basis of economic costs or resource cost would not necessarily be financially viable unless the existing prices are determined by the economic costs. That imply that the survival of the projects would depend either on the government’s continuing ability to give them subsidies, a condition that becomes more difficult as the politico-economic turbulence of

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the 1970s unfolded. The alternative and the recommended option for the government is to dismantle the interventions that prevent projects from being profitable. To give an example, in the middle of 1980s, the Planning Commission built up a transport-planning model on the basis of economic costs where labour labour, foreign exchange and energy costs were shadow-priced. Financial wage costs were reduced by 20 percent, while energy costs were enhanced by 20 percent and foreign exchange costs were enhanced by 25 percent (i.e. shadow price of labour was taken as 0.8, and shadow price of energy as 1.2 and shadow price of foreign exchange as 1.25). On the basis of economic cost, road transport cost was observed to be lower than the rail transport cost for short distance, while rail transport had comparative advantage for long distance. On this basis, modal shares for rail and road were projected for future, and required capacity expansions were proposed. It was estimated that rail should have a share of 75 percent in total goods and passenger traffic. However, rail passenger fares and freight rates for goods traffic were not determined on the basis of economic costs. As a result, over the years, actual modal shares became completely irrational and non-optimal, 75 percent by roads and 25 percent by rail, resulting in loss of public resources. 3. Identificaton of Benefits and Costs In social cost benefit analysis, the most important and the most difficult task is to identify and measure all social costs and benefits associated with the projects. These costs and benefits arise due to externalities of the project. They relate to local resources, ecosystem and overall environment. While the technical feasibility and the financial viability excercises are well developed and there are conventional methods to conduct those studies, economic and social cost-benefit analysis depend on the purpose of the studies. Let me discuss these problems in relation to two project reports submitted to the Ministry of Rural Development, which I had a chance to look at.

4. Evaluation of Poverty Alleviation Programs Growth with social justice and alleviation of poverty have been primary objectives of Indian planning since its inception in 1951. Several anti-poverty programs have been in operation for decades focussing the poor as the target groups. These include programs for the welfare of weaker sections, women and children, and a number of special employment programs for self- and wage employment in rural and urban areas. The ongoing economic reforms since 1991 have also a human face and attached high priority to the development of social sectors.

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The government has relied mainly on two approaches for poverty alleviation: the first based on the anticipation that economic growth will have a “trickle down effect” on the levels of living of all groups in society; and the second that direct anti-poverty programs are also required. More recently, government shifted public expenditure away from investment in infrastructure and industry towards social sectors, and improved targeting of subsidies through changes in the public distribution system. Anti-poverty programs have been strengthened over the years to generate more employment, create productive assets, impart technical and entrepreneurial skills and raise the income level of the poor. But most evaluations - whether done by the government or others - agree that these programs have not been very effective in reducing poverty, as these suffer from ill-defined multiple objectives, limited targeting towards the poor, under-funding and often complex administration, high administrative costs and leakage, lack of proper accountability and adequate monitoring. For example, a recent study of the Public Distribution System (PDS) suggested that as little as 25 per cent of the foodgrains actually reach the poorest 40 per cent of the population and that administrative costs far outweigh the income gains to the poor. In general, it costs the government between 2 and 7 rupees (with the highest value reported for the PDS) to provide one rupee to the poor. One of the better-targeted programs is the Integrated Child Development Services (ICDS). Similarly, public works have been relatively more successful at targeting the poor and have improved significantly the living standards of a large number of poor at a relatively low cost.

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DR. TARUN DAS Professor and Area Head (Economics) Institute for Integrated Learning in Management 3 Lodhi Institutional Area, New Delhi-11000 Tel: 2588-4540, Mobile: 9818024569 E-mail: [email protected]/ [email protected] Brief Bio-data •

Dr. Tarun Das is a development economist with 35 years experience. He is presently working as Professor (Public Policy) in the Institute for Integrated Learning in Management, New Delhi. Earlier, he worked as an Economic Adviser in the Ministry of Finance and the Planning Commission, Chief Economist, Ministry of Steel, and Chief (Eco. Division) in the Bureau of Industrial Costs and Prices.

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He is a Gold Medallist in Economics from Calcutta University, and holds a Ph.D. degree as Commonwealth Scholar from the East Anglia University, England.

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He was a Member of the high-level government delegations to the IMF, World Bank, ESCAP, UCTAD, WTO, and UN Commission on Sustainable Development.

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He also worked as a Consultant to the World Bank, Asian Development Bank, Economic Commission for Africa, UNDP, United Nations Institute for Training and Research (UNITAR), UN-ESCAP and International Labour Organisation (ILO).

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He is a widely traveled person and possesses diversity in skills in teaching, training, research, policy planning and modeling. He is an acknowledged expert in the field of economic reforms, transport modeling, project appraisal, poverty and inequality, foreign investment policies and management of external debt; and has published a number of books and papers on these subjects

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