8. Economic Soundness. Introduction to Cost-Benefit Analysis

This section introduces[16] the concepts of Cost-Benefit Analysis and economic analysis.

The most refined form of economic analysis is the Cost-Benefit Analysis methodology. It assesses the social cost-benefit equation, in which the benefits for society have to be higher than the costs to the public for the project to be worthy of proceeding. It is an exercise that aims to include all relevant costs and benefits. This is done with a long-term perspective, projecting both costs and benefits through the analysis period. The period considered has to be in line with the useful economic life of the infrastructure asset.

When considering benefits in the Cost–Benefit analysis, benefits have to be considered in the broad sense of the term: direct or indirect, internal and external (that is, external are those that affect or benefit third parties beyond the population to which the project is addressed in a first instance). In order to estimate direct benefits, the first step would be to research whether there is available market data regarding the specific benefit.

In cases in which benefits appear as cost savings, the quantification of a benefit is implicit in the cost estimate of the alternatives under analysis (for example, the project will lead to lower congestion levels or will increase mobility, the project will substitute an old facility and generate environmental savings by means of lowering pollution, and so on).

When valuing project costs and benefits, a quantification problem can arise. Most of the costs are direct costs (such as the cost of the investment itself, the public works), but the project may have other indirect costs and benefits as well as positive and negative “externalities[20]” (such as environmental effects, damage to a certain population, such as commercial business affected by the works or the site of the project, and so on). Box 3.8 sets out the impact of some common externalities.

Costs should reflect the best alternative use of the goods (opportunity cost[22]) to the extent to which it is possible.

• Although market prices are the best way to reflect the opportunity cost, in some circumstances they may not do so accurately (distortions in the specific market for the good or service due to monopolies or other market imperfections); and
• There is a need to discount the effect of taxes in the prices/costs, as they are part of the nominal value of the cost (in terms of cash flows), but do not imply a cost in terms of society (but in fact are a revenue for the government).

Dealing with benefits is especially challenging since all benefits have to be quantified. Benefits often relate to the “opportunity cost” concept. Time savings are a clear example (in the field of transportation projects).

Determining the unit of analysis and its monetary value is not an easy exercise for many intangible variables (such as quality of life, security of a neighbourhood). One alternative to determine its monetary value is to assess the highest price an individual is willing to agree to pay for a good or a service. As described by Breidert (2005)[23]:

“How much a person is willing to pay depends on the perceived economic value and on the utility of the good. These two values determine whether the price a person is willing to accept is the reservation price or the maximum price. If a person believes that there is no alternative offering, the highest amount of money he or she is willingness to pay equals the utility of the good and is the reservation price. If a person perceives an alternative offering with an economic value below utility, the highest price he or she would accept equals the economic value of the product and is the maximum price.”

Where it is difficult to determine the monetary value of a benefit, it can be useful to consider values from studies in other countries, although care is necessary in interpreting these as the value (for example, willingness to pay) in one country may be different from another.

If it is decided not to quantify a specific benefit, the benefit should be treated qualitatively and considered or included in the analysis in addition to the quantitative results. In this case, even when it is not possible to express all of the benefits or costs in quantitative terms, it is possible to reveal important aspects for decision-makers.

In socio-economic terms, it may be said that there is a need to demonstrate that a project’s social and economic benefits are higher than its costs. The first act is to demonstrate social and economic benefits in quantitative terms. When this is not possible, it may be handled through a qualitative analysis, describing the main advantages and the value added by the project to the society in terms of relevant magnitudes, defined in accordance with the authority’s strategic plan and global strategic objectives.

Table 3.1, taken from Kee (2005), provides a framework for Cost-Benefit Analysis with examples and generally accepted approaches to valuation of the benefits and costs.

Once the direct costs are duly adjusted and the externalities (external costs and benefits) are identified and quantified, a number of additional adjustments should be made before the results of the analysis are calculated and presented.

• Adjustment for inflation: it is advisable to construct projections in real terms, since a correction for cost projections should be done for those cost items that are considered likely not to follow the general Consumer Price Index (CPI). This is usually considered as corrections in relative price changes; and
• Adjustment for risk and uncertainty (section 2.8.2).